Question

leased the asset on a 2-year lease, the payment would be $110 at the begin- ning of each year. If RC borrowed and bought, the bank would charge 10% interest on the loan. In either case, the equipment is worth nothing after 2 years and will be discarded. Should RC lease or buy the equipment?

Answer 1

you should purchase the asset using a bank loan

Step-by-step explanation:

in order to compare both options, we need to determine the present value of each alternative:

present value of lease costs:

cash flow year 0 = $110

cash flow year 1 = $110

PV = $110 + $110/1.1 = $110 + $100 = $210

present value of purchasing the equipment:

cash flow year 0 = $0

cash flow year 1 = $115.24

cash flow year 2 = $115.24

PV = $200

if you consider the tax shield of leasing = ($220 - $200) x tax rate = $20 x 40% = $8

the tax shield of interest expense = ($230.48 - $200) x tax rate = $30.48 x 40% = $12.19

It doesn't matter how you analyze this, buying is a better and cheaper option. The problem with leasing is that you need to make an immediate payment, while if you borrow money, then the first payment is made in the future. The time value of money is different.