FRC, Inc. is considering to install $1.5 million of new equipment in its new factory. It can get a 5-year bank loan for the cost of the equipment at a 10% interest rate. The bank asks for equal payments at the end of each year. FRCs tax rate is 30%. The equipment falls in the MACRS 3-year category. The other way FRC can use the equipment is through a guideline lease. The lease payments are $350,000 at the end of each year for the next 3 years. If FRC goes with the lease agreement, it will have to pay for insurance, taxes and maintenance. FRC also knows that it must continue using the equipment, so it will certainly want to purchase the equipment at the end of the lease. According to the lease terms, it can be purchased at its fair market value at Year 3. The best estimate FRC has for this market value is $300,000, but it could be higher or lower under certain circumstances. If purchased at the end of the lease agreement, the equipment would fall in the MACRS 3-year category. FRC will be able to report the depreciation expenses in the following four years, at year 4, 5, 6, and 7.

Question 1:

What is the Net Advantage of Leasing? Should FRC take the lease?

Question 2:

The uncertainty in the level of the residual value estimate was mentioned above. How high/low could the residual value get so that the net advantage of leasing becomes zero?