Morris Company, a small manufacturing firm, wants to acquire a new machine that costs $30,000. Arrangements can be made to lease or purchase the machine. The firm is in the 40% tax bracket. The firm has gathered the following information about the two alternatives: Lease: Morris would obtain a five-year lease requiring annual end-of-year lease payments of $10,000. The lessor would pay all maintenance costs; insurance and other costs would be borne by the lessee. Morris would be given the right to exercise its option to purchase for $3,000 at the end of the lease term Purchase: Morris can finance the purchase of the machine with an 8.5% five-year loan requiring annual end-of -year installment payments. The machine would be depreciated under MACRS using a five-year recovery period. The exact depreciation rates over the next six periods would be 20%, 32%, 19%, 12%, 12% and 5% respectively. Morris would pay $1200 per year for a service contract that covers all maintenance costs. The firm plans to keep the machine and use it beyond its five-year recovery period.

a) Calculation of after-tax cash outflow from the lease for Morris Company:

After-tax cash outflow = Lease payment * (1-tax rate) = 10000 * (1-40%) = $6,000

b) Calculation of annual loan payment:

Annual loan payment: Loan / ((1-(1+r)^-n) / r) = 30000 / ((1-(1+8.5%)^-5) / 8.5%) = $7,612.97

c) Calculation of interest and principal components of the loan payments:

A	B	C	D=B*8.5%	E=C-D	F=B-E
Year	Beginning Balance	Annual Payment	Interest	Principal	Balance at EOY
1	$ 30,000.00	$ 7,612.97	$ 2,550.00	$ 5,062.97	$ 24,937.03
2	$ 24,937.03	$ 7,612.97	$ 2,119.65	$ 5,493.32	$ 19,443.71
3	$ 19,443.71	$ 7,612.97	$ 1,652.72	$ 5,960.25	$ 13,483.45
4	$ 13,483.45	$ 7,612.97	$ 1,146.09	$ 6,466.88	$ 7,016.58
5	$ 7,016.58	$ 7,612.97	$ 596.39	$ 7,016.58	$ (0.00)

d) Calculation of after-tax cash outflows associated with the purchasing option:

A	B	C=refer part c	D=WN1	E	F=C+D+E	G=F*tax rate	H=WN1	I=refer part c	J=B+F+G+H+I
Year	Initial Investment	Loan Interest repayment	Depreciation	Maintenance Cost	Cash flow before tax	Tax @ 40%	Add back Depreciation	Loan Principal repayment	Cash flow after tax
0	$(30,000.00)								$(30,000.00)
1		$ (2,550.00)	$ (6,000.00)	$ (1,200.00)	$ (9,750.00)	$ 3,900.00	$ 6,000.00	$(5,062.97)	$(4,912.97)
2		$ (2,119.65)	$ (9,600.00)	$ (1,200.00)	$(12,919.65)	$ 5,167.86	$ 9,600.00	$(5,493.32)	$(3,645.11)
3		$ (1,652.72)	$ (5,700.00)	$ (1,200.00)	$ (8,552.72)	$ 3,421.09	$ 5,700.00	$(5,960.25)	$(5,391.88)
4		$ (1,146.09)	$ (3,600.00)	$ (1,200.00)	$ (5,946.09)	$ 2,378.44	$ 3,600.00	$(6,466.88)	$(6,434.53)
5		$ (596.39)	$ (3,600.00)	$ (1,200.00)	$ (5,396.39)	$ 2,158.56	$ 3,600.00	$(7,016.58)	$(6,654.41)

WN1: Calculation of depreciation:

A	B	C	D=B*C
Year	Opening WDV	Depreciation Rate	Depreciation
1	$ 30,000.00	20%	$ 6,000.00
2	$ 30,000.00	32%	$ 9,600.00
3	$ 30,000.00	19%	$ 5,700.00
4	$ 30,000.00	12%	$ 3,600.00
5	$ 30,000.00	12%	$ 3,600.00

The question:

e. Calculate and compare the present values of the cash outflows associated with both the leasing and purchasing options. Show your work.

f. Which alternative is preferable? Explain.