P17-4 Lease versus purchase

JLB Corporation is attempting to determine whether to lease or purchase research equipment. The firm is in the 23% taxbracket, and itsafter-tax cost of debt is currently 9%. The terms of the lease and of the purchase are asfollows:

LeaseAnnualend-of-year lease payments of $20,000 are required over the3-year life of the lease. All maintenance costs will be paid by thelessor; insurance and other costs will be borne by the lessee. The lessee will exercise its option to purchase the asset for $6,500 at termination of the lease. Ignore any future tax benefit associated with the purchase of the equipment at the end of year 3 under the lease option.

PurchaseThe researchequipment, costing $50,000, can be financed entirely with a 12% loan requiring annualend-of-year payments of $20,817 for 3 years. The firm in this case will depreciate the equipment under MACRS using a3-year recovery period. The firm will pay $1,600 per year for a service contract that covers all maintenancecosts; insurance and other costs will be borne by the firm. The firm plans to keep the equipment and use it beyond its3-year recovery period.

a.Calculate the after-tax cash outflows associated with each alternative.(Hint: Because insurance and other costs are borne by the firm under bothalternatives, those costs can be ignoredhere.)

b. Calculate the present value of each cash outflowstream, using theafter-tax cost of debt.

c.Which alternativelease or purchaseis best? Why?