LEASE VERSUS BUY Morris-Meyer Mining Company must install $1.5million of new machinery in its Nevada mine. It can obtain a bankloan for 100% of the required amount. Alternatively, a Nevadainvestment banking firm that represents a group of investorsbelieves that it can arrange for a lease financing plan. Assumethat the following facts apply: The equipment falls in the MACRS3-year class. The applicable MACRS rates are 33%, 45%, 15%, and7%.
2. Estimated maintenance expenses are $75,000 per year.
3. Morris-Meyer’s federal-plus-state tax rate is 40%.
4. If the money is borrowed, the bank loan will be at a rate of15%, amortized in 4 equal installments to be paid at the end ofeach year.
5. The tentative lease terms call for end-of-year payments of$400,000 per year for 4 years.
6. Under the proposed lease terms, the lessee must pay forinsurance, property taxes, and maintenance.
7. The equipment has an estimated salvage value of $400,000,which is the expected market value after 4 years, at which timeMorris-Meyer plans to replace the equipment regardless of whetherthe firm leases or purchases it. The best estimate for the salvagevalue is $400,000, but it may be much higher or lower under certaincircumstances.
To assist management in making the proper lease-versus-buydecision, you are asked to answer the following questions.
a. Assuming that the lease can be arranged, should Morris-Meyerlease or borrow and buy the equipment? Explain.
b. Consider the $400,000 estimated salvage value. Is itappropriate to discount it at the same rate as the other cashflows? What about the other cash flows—are they all equally risky?Explain.
