Question

Kiddy Toy Corporation needs to acquire the use of a machine to be used in its manufacturing process. The machine needed is manufactured by Lollie Corp. The machine can be used for 10 years and then sold for $25,000 at the end of its useful life. Lollie has presented Kiddy with the following options:

1. Buy machine. The machine could be purchased for $175,000 in cash. All insurance costs, which approximate $20,000 per year, would be paid by Kiddy.

2. Lease machine. The machine could be leased for a 10-year period for an annual lease payment of $40,000 with the first payment due immediately. All insurance costs will be paid for by the Lollie Corp. and the machine will revert back to Lollie at the end of the 10-year period.

Required:

Assuming that a 10% interest rate properly reflects the time value of money in this situation and that all maintenance and insurance costs are paid at the end of each year, find the present value for the following options. Ignore income tax considerations. Determine which option Kiddy should choose.

PV

Buy option

Lease option

Kiddy should choose

Answer 1

To determine whether Kiddy should buy or lease the machine, we need to calculate the present value of both options using an interest rate of 10%. If the present value of the buy option is greater, Kiddy should buy the machine. Otherwise, Kiddy should lease the machine.

Step-by-step explanation:

To determine whether Kiddy should buy or lease the machine, we need to calculate the present value of both options.

For the buy option, we will calculate the present value of the $175,000 cash outflow for the purchase, as well as the present value of the $20,000 insurance cost each year for 10 years. We use the interest rate of 10% to discount these cash flows to their present value. At the end of the 10-year period, there will also be a cash inflow of $25,000 from selling the machine, which we also need to discount to its present value. Adding up all the present values gives us the present value of the buy option.

For the lease option, we will calculate the present value of the $40,000 annual lease payment for 10 years. Since the insurance costs are paid for by Lollie Corp., we don't need to discount them. At the end of the 10-year period, the machine will revert back to Lollie, so there is no cash inflow to discount. Adding up all the present values gives us the present value of the lease option.

Finally, we compare the present values of the buy and lease options. If the present value of the buy option is greater than the present value of the lease option, Kiddy should choose to buy the machine. Otherwise, Kiddy should choose to lease the machine.

Answer 2

To determine the present value, we need to calculate the present value of the cash flows associated with each option. The buy option has a total present value of $300,396.23, while the lease option has a present value of $258,442.39. Therefore, Kiddy should choose the lease option.

Step-by-step explanation:

To determine the present value of the options, we need to calculate the present value of the cash flows associated with each option. For the buy option, the present value would be the sum of the cash outflows for the purchase price and the annual insurance costs discounted using a 10% interest rate. For the lease option, the present value would be the sum of the lease payments discounted using a 10% interest rate, as there are no cash outflows for insurance costs. By comparing the present values of the two options, we can determine which one Kiddy should choose.

1. Buy option:
   • Purchase price: $175,000
   • Annual insurance costs: $20,000
   • Present value of purchase price: $175,000
   • Present value of insurance costs: $20,000 / (1.1^1) + $20,000 / (1.1^2) + ... + $20,000 / (1.1^10) = $125,396.23
   • Total present value: $175,000 + $125,396.23 = $300,396.23
2. Lease option:
   • Annual lease payment: $40,000
   • Present value of lease payment: $40,000 / (1.1^1) + $40,000 / (1.1^2) + ... + $40,000 / (1.1^10) = $258,442.39

Based on the present values, Kiddy should choose the lease option as it has a lower present value compared to the buy option.