High electricity costs have made Farmer Corporation's chicken- plucking machine economically worthless. Only two machines are available to replace it. The International Plucking Machine (IPM) model is available only on a lease basis. The lease payments will be $27,000 for five years, due at the beginning of each year. This machine will save Farmer $12,000 per year through reductions in electricity costs in every year.
As an alternative, Farmer can purchase a more energy-efficient machine from Basic Machine Corporation (BMC) for $150,000. This machine will save $20,000 per year in electricity costs. A local bank has offered to finance the machine with a $150,000 loan. The interest rate on the loan will be 10 percent on the remaining balance and will require five annual principal payments of $30,000. Farmer has a target debt-to-asset ratio of 67 percent. Farmer is in the 34 percent tax bracket.
After five years, both machines will be worthless. The machines will be depreciated on a straight-line basis.
a. Should Farmer lease the IPM machine or purchase the more efficient BMC machine?
b. Does your answer depend on the form of financing for direct purchase?
c. How much debt is displaced by this lease?