Question:

PENC Corporation is attempting to determine whether to lease or purchase office equipment for its newly established Zonal office in Karachi. The firm is in the 40 percent tax bracket, and its after-tax cost of debt is currently 8 percent. The term of the lease and the purchase are as follows:

Lease:Annualend-of-year lease payments of Rs.25,200 are required over 3 year life of the lease. All maintenance costs will be paid by the lessor; insurance and other costs will be borne by the lessee. The lessee will exercise its option to purchase the asset for Rs.5000 at termination of the lease.

Purchase:The office equipment, costing Rs.60,000, can be financed entirely with a 14 percent loan requiring annual end-of-year payments of Rs.25,844 for 3 years. Depreciation charges will be 33% in the first year, 45% in the second year and 15% in the third year. The firm will pay Rs.1,800 per year for a service contract that covers all maintenance costs; insurance and other costs will be borne by the firm. The firm plans to keep the equipment and use it beyond its 3 year recovery period.

Required:

a. Calculate the after-tax cash outflows associated with each alternative.

b. Calculate the present value of each cash outflow stream using the after-tax cost of debt.

c. Which alternative, lease or purchase the equipment, would you recommend? Why?