LEASE VERSUS BUY Morris-Meyer Mining Company must install $1.5 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: The equipment falls in the MACRS 3-year class. The applicable MACRS rates are 33%, 45%, 15%, and 7%.

2. Estimated maintenance expenses are $75,000 per year.

3. Morris-Meyers federal-plus-state tax rate is 40%.

4. If the money is borrowed, the bank loan will be at a rate of 15%, 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 $400,000 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 $400,000, which is the expected market value after 4 years, at which time Morris-Meyer plans to replace the equipment regardless of whether the firm leases or purchases it. The best estimate for the salvage value is $400,000, 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 Morris-Meyer lease or borrow and buy the equipment? Explain.

b. Consider the $400,000 estimated salvage value. Is it appropriate to discount it at the same rate as the other cash flows? What about the other cash flowsare they all equally risky? Explain.