GMS Corporation is attempting to determine whether to lease or purchase research equipment. The firm is in the 40 percent tax bracket, and its after tax cost of debt is currently 6 percent. The terms of the lease and the purchase are as follows:
Lease. Annual beginning-of-year lease payments of $93,500 are required over the three-year life of the lease. The lessor will pay all maintenance costs; the lessee will pay insurance and other costs. The lessee will exercise its option to purchase the asset for $25,000 paid along with the final lease payment. Purchase. The $250,000 cost of the research equipment can be financed entirely with a 10 percent loan requiring annual end-of-year payments of $100,529 for three years. The firm in this case will depreciate the equipment under MACRS using a three-year recovery period. (See Table 9.1 for applicable MACRS percentages.)
The firm will pay $9,500 per year for a service contract that covers all maintenance costs; the firm will pay insurance and other costs. The firm plans to keep the equipment and use it beyond its three-year recovery period.
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, would you recommend? Why?