Heavy Kat’s Ltd. (HK) is looking at acquiring new equipment for the production of the HKMV55, which will cost $7 million and has an estimated useful life of 10 years. For accounting purposes, this equipment will also be depreciated on a straight-line basis. It belongs to an asset class with a CCA rate of 10%. The equipment has an estimated salvage value of $500,000 at the end of its useful life. As the equipment qualifies for the Accelerated Investment Incentive, 1.5 times the CCA can be taken in the year of acquisition. At the end of the planning horizon, assume that there is still a positive balance remaining in the class after the deduction of the proceeds. HK’s corporate tax rate is 28%. Using a 12% discount rate, HK has determined that the acquisition is economically viable.

HK has the option of leasing the new equipment for a 10-year period at annual payments of $1,000,000 at the beginning of each year, and it can borrow from its bank at an after-tax interest rate of 4.1%.

Required:

1. Should HK lease or purchase the equipment?
2. Why is the after-tax cost of borrowing the appropriate discount rate for use in a purchase or lease decision?