Question

Kiddy Toy Corporation needs to acquire the use of a machine to be used in its manufacturing process. The machine needed is manufactured by Lollie Corp. The machine can be used for 10 years and then sold for $22,000 at the end of its useful life. Lollie has presented Kiddy with the following options: (FV of $1, PV of $1, FVA of $1, PVA of $1, FVAD of $1 and PVAD of $1) (Use appropriate factor(s) from the tables provided.)

1. Buy machine. The machine could be purchased for $172,000 in cash. All insurance costs, which approximate $17,000 per year, would be paid by Kiddy.

2. Lease machine. The machine could be leased for a 10-year period for an annual lease payment of $37,000 with the first payment due immediately. All insurance costs will be paid for by the Lollie Corp. and the machine will revert back to Lollie at the end of the 10-year period.

Required:
Assuming that a 10% interest rate properly reflects the time value of money in this situation and that all maintenance and insurance costs are paid at the end of each year, determine which option Kiddy should choose. Ignore income tax considerations. (Negative amounts should be indicated by a minus sign. Round your final answers to nearest whole dollar amount.)
  

Answer 1

a. Buying alternative:

Since taxes are ignored, we need not worry about depreciation.

Year		Cash Outflow (A)	PV Factor @ 10% (B)	Discounted Cashflow (A*B)
0	Initial Outlay	-172000	1.0000	-172000.00
1	Insurance	-17000	0.9091	-15454.55
2	Insurance	-17000	0.8264	-14049.59
3	Insurance	-17000	0.7513	-12772.35
4	Insurance	-17000	0.6830	-11611.23
5	Insurance	-17000	0.6209	-10555.66
6	Insurance	-17000	0.5645	-9596.06
7	Insurance	-17000	0.5132	-8723.69
8	Insurance	-17000	0.4665	-7930.63
9	Insurance	-17000	0.4241	-7209.66
10	Insurance	-17000	0.3855	-6554.24
10	Salvage value	22000	0.3855	8481.95
			Total PV of Cash outflow	-267975.69

b. Leasing Alternative:

10 Year old lease period where first installment is made at inception of lease ie year 0. Insurance is borne by lessor and machine reverts to lessor. So no adjustments required. Accordingly,

Year		Cash Outflow (A)	PV Factor @ 10% (B)	Discounted Cashflow(A*B)
0	Initial lease payment	-37000	1.0000	-37000.00
1	annual lease payment	-37000	0.9091	-33636.36
2	annual lease payment	-37000	0.8264	-30578.51
3	annual lease payment	-37000	0.7513	-27798.65
4	annual lease payment	-37000	0.6830	-25271.50
5	annual lease payment	-37000	0.6209	-22974.09
6	annual lease payment	-37000	0.5645	-20885.54
7	annual lease payment	-37000	0.5132	-18986.85
8	annual lease payment	-37000	0.4665	-17260.77
9	annual lease payment	-37000	0.4241	-15691.61
			Total PV of Cash outflow	-250083.88

PV of Cash flow under Buying option	-267975.69
PV of Cash flow under Leasing option	-250083.88
Difference	-17891.81

Hence, Leasing Alternative is preferable as it yields lesser outflow based on our above computations.