LEASE VERSUS BUY

20-5 LEASE VERSUS BUY Sullivan-Swift Mining Company must install $1.2 million of new machinery in its Nevada mine. It can obtain a bank loan for 100% of the required amount. Alternatively, a Nevada investment banking firm that represents a group of investors believes that it can arrange for a lease financing plan. Assume that the following facts apply: 1. The equipment falls in the MACRS 3-year class. The applicable MACRS rates are 33%, 45%, 15%, and 7%. 2. Estimated maintenance expenses are $80,000 per year. 3. Sullivan-Swift's federal-plus-state tax rate is 45%. 4. If the money is borrowed, the bank loan will be at a rate of 13%, amortized in 4 equal installments to be paid at the end of each year. 5. The tentative lease terms call for end-of-year payments of $300,000 per year for 4 years. 6. Under the proposed lease terms, the lessee must pay for insurance, property taxes, and maintenance. 7. The equipment has an estimated salvage value of $300,000, which is the expected market value after 4 years, at which time Sullivan-Swift plans to replace the equip- ment regardless of whether the firm leases or purchases it. The best estimate for the salvage value is $300,000, but it may be much higher or lower under certain circumstances. To assist management in making the proper lease-versus-buy decision, you are asked to answer the following questions. a. Assuming that the lease can be arranged, should Sullivan-Swift lease or borrow and buy the equipment? Explain. b. Consider the $300,000 estimated salvage value. Is it appropriate to discount it at the same rate as the other cash flows? What about the other cash flows--are they all equally risky? Explain