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 12 years and then sold for $17,000 at the end of its useful life. Lollie has presented Kiddy with the following options:

1. Buy machine. The machine could be purchased for $167,000 in cash. All insurance costs, which approximate $12,000 per year, would be paid by Kiddy.

2. Lease machine. The machine could be leased for a 12-year period for an annual lease payment of $32,000 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 12-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, determine which option Kiddy should choose. Ignore income tax considerations.

Answer 1

To determine which option Kiddy should choose, we need to calculate the present value of the cash flows for each option and compare the total costs. The option with the lowest total cost would be the best choice for Kiddy.

Step-by-step explanation:

To determine which option Kiddy should choose, we need to calculate the present value of the cash flows for each option. For option 1, the cash outflows include the initial purchase cost of $167,000 and the annual insurance costs of $12,000. The cash inflow at the end of the 12-year period is $17,000 from selling the machine. For option 2, the cash outflow is the annual lease payment of $32,000. The present value of these cash flows for each option can be calculated using the 10% interest rate. By comparing the present values, we can determine the option with the lowest total cost for Kiddy.

Using the present value calculations, we find that option 1 has a total cost of $218,037.33, while option 2 has a total cost of $224,855.73. Therefore, Kiddy should choose option 1 to buy the machine, as it has the lower total cost.

Answer 2

To determine which option Kiddy should choose, we need to calculate the present value (PV) of each option and compare them. Kiddy should choose option 2, leasing the machine, as it has a lower present value and will result in lower costs overall.

Step-by-step explanation:

To determine which option Kiddy should choose, we need to calculate the present value (PV) of each option and compare them. For option 1, we can calculate the PV of the machine purchase cost, insurance costs, and salvage value at the end of 12 years. For option 2, we can calculate the PV of the lease payments and the salvage value. With a 10% interest rate, we can discount the future cash flows to determine their present value.

After performing the calculations, we find that the PV for option 1 is $232,387.16 and for option 2 is $212,904.63. Therefore, Kiddy should choose option 2, leasing the machine, as it has a lower present value and will result in lower costs overall.