Jolly Company has decided to acquire office equipment (copiers, printers, etc.) that it will use at its headquarters building for the next five years. The equipment would cost $400,000 to purchase. Alternately, Jolly could lease the equipment for five years, at an annual cost of $120,000. The lease includes equipment maintenance, which would otherwise be anticipated to cost $30,000 per year.

The estimated salvage value of the equipment after five years is $90,000. The five-year MACRS schedule applies for tax depreciation. Jolly tax rate for both income and capital gains is 34%. You can assume that, should Jolly purchase the equipment, it will borrow $400,000 to do so. The loan would call for Jolly to pay $32,000 per year in interest (8%), and to repay the principal after at the end of year five.

The appropriate discount rate for this problem is 5.28% (the after tax cost of borrowing). You can also assume that Jolly would earn this rate (after tax) on any cash balances. All cash flows except the initial purchase and borrowing are end-of-period. Finally, you can assume that Jolly taxable income is high enough that the tax deductible expenses associated with this decision would indeed reduce the companys tax liability.

a) Suppose that Jolly wanted to set aside a sum of money now that would be sufficient to fund the after-tax costs of acquiring the assets through the lease. How much money would they need to set aside?

(b) Suppose that Jolly wanted to set aside a sum of money now that would be sufficient to fund the after-tax costs of acquiring the assets through the borrow to purchase alternative. How much money would they need to set aside?

(c) Which alternative do you recommend, and why?