Discount Cash Flow Analysis

The Optimo Company in operating 10 sugar plantations used large amounts of heavy equipment. Optimo has been approached by a leasing company which has offered to lease Optimo many kinds of equipment. As an example, the leasing company has offered the following terms on a $21,500 truck.

Years Lease Payment

1 $4,000

2 4,000

3 3,600

4 3,600

5 3,600

6 3,600

7 3,600

Optimo estimates that operating savings from using this truck will be $12,000 per year.

If Optimo buys the truck it will be able to write it off to a residual of $500 over a 7 year period.

Tax rate for this company is 30%

Show costs and earnings in a form which would be used if Optimo were to use the discounted cash flow method of analyzing the lease vs. purchase decisions. What should their choice be-lease or purchase?

Note to Optimo:

We begin with the assumption that the truck is needed. We can lease it, but we want to know whether it would be profitable to go one-step further-that is, purchase it. The question to be answered is this: Will the differential investment, purchase vs. lease, yield a higher rate of return than the firm's cost of capital? If it is higher, we purchase the truck; if not, we will lease it.

How would the decision change if the savings from using the truck were $20,000 per year? Reanalyze the problem and comment on the results and the affects of the increased earnings on the analysis.