Question

(20pts) You are planning on acquiring a machine for a business that you have just started. The machine costs $35,000 and you can get a 5 year term loan at 10%; the principal amount will be paid at the end of the five years. The machine will be depreciated at a rate of $6,000 every year. At the end of 5 years, the machine will have a value of $5,000. The manufacturer of the equipment is willing to lease the machine for $8,000 a year, with lease payments due at the end of the year. If the firm leases it will acquire the machine for $5,000 at the end of 5 years. This cost of $5000 already accounts for related future depreciation tax savings. The tax rate for your business is 35%. Should you buy or lease? (Cost of lease =$25,259, Cost of buying =$26,273.

Answer 1

To decide on whether to buy or lease a machine for your business, calculate the costs of buying and leasing over 5 years. Buying the machine would cost $10,000 and leasing would cost $35,000, making buying the more cost-effective.

Step-by-step explanation:

To decide on whether to buy or lease the machine for your business, we need to compare the costs of buying and leasing over the 5 years. Let's calculate the costs:

1. Buying: The cost of buying the machine is $35,000. The machine will be depreciated by $6,000 every year, so the total depreciation over 5 years will be $30,000. At the end of 5 years, the machine will have a value of $5,000. So the total cost of buying is $35,000 - $30,000 + $5,000 = $10,000.
2. Leasing: The cost of leasing the machine for 5 years is $8,000 per year, so the total cost of leasing is $8,000 x 5 = $40,000. However, at the end of 5 years, you can acquire the machine for $5,000, which already accounts for the related future depreciation tax savings. So the total cost of leasing is $40,000 - $5,000 = $35,000.

Comparing the costs, buying the machine would cost $10,000 and leasing the machine would cost $35,000. Therefore, you should buy the machine as it is the more cost-effective option.

Answer 2

Upon calculating the cost of buying and the cost of leasing the machine, including tax shields from interest and depreciation, the total cost of buying is $30,875, while leasing costs $31,000. Therefore, it is more economical for the business to buy the machine.

Step-by-step explanation:

The question relates to making a financial decision on whether to buy or lease a machine for business purposes, considering factors such as the cost of purchase, the terms of the loan, the depreciation rate, the residual value after five years, lease costs, and the tax rate.

To tackle this problem, we must calculate the total cost of buying and leasing, including tax considerations and compare to determine the more economical option for the business.

Firstly, calculating the cost of buying: The machine costs $35,000 financed by a loan at a 10% interest rate (interest-only payments), with principal repayment at the end of year 5.

Yearly depreciation is $6,000, and the tax rate is 35%, so the tax shield from depreciation is $6,000 x 35% = $2,100. Annual interest is $35,000 x 10% = $3,500, and the tax shield from the interest is $3,500 x 35% = $1,225. The cost of buying after tax savings would be:

Interest cost for five years: $3,500 x 5 = $17,500.

Interest tax shield: $1,225 x 5 = $6,125.

Depreciation tax shield: $2,100 x 5 = $10,500.

Final payment (principal amount): $35,000.

Minus residual value: -$5,000.

Total cost of buying = $17,500 + $35,000 - $6,125 - $10,500 - $5,000 = $30,875.

Secondly, the cost of leasing for five years is $8,000 per year. The tax shield is $8,000 x 35% = $2,800. Thus, the cost of leasing after tax is:

Lease payments over five years: $8,000 x 5 = $40,000.

Minus lease payment tax shield: -$2,800 x 5 = -$14,000.

Plus cost of acquiring machine at end of lease: +$5,000.

Total cost of leasing = $40,000 - $14,000 + $5,000 = $31,000.

Comparing both options, the total cost of buying is $30,875, while the total cost of leasing is slightly higher at $31,000. Therefore, buying the machine is the cheaper option over the long term for the business.