P 613 Lease vs buy alternatives 063 LO67g LO69 Kiddy Toy

P 6-13 Lease vs. buy alternatives ?06-3 @ , LO6-7g. LO6-9 @ 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 $10,.000 at the end of its useful life. Lollie has presented Kiddy with the following options: 1. Buy machine. The machine could be purchased for $160,000 in cash. All insurance costs, which approximate $5,000 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 $25,000 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 12% 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

Solution

Calculation of Net Present value of Outflows

Buy Option

Year

Inflow (Outflow)

Present value factor at 12% discount rate

Discounted Inflow (Outflow)

0

$ (160,000.00)

1

$              (160,000.00)

1-10

$      (5,000.00)

5.6502

$                 (28,251.12)

10

$      10,000.00

0.3220

$                     3,219.73

Present value of Total Outflows

$              (185,031.38)

*$ 1000 is inflow in year 10 for sale of Machine

Calculation of Net Present value of Outflows

Lease Option

Year

Outflow

Present value factor at 12% discount rate

Discounted Inflow (Outflow)

0

$    (25,000.00)

1

$                 (25,000.00)

.1-9

$    (25,000.00)

5.3282

$              (133,206.24)

Present value of Total Outflows

$              (158,206.24)

Final Analysis

PV

Buy Option

$ (185,031.38)

Lease Option

$ (158,206.24)

Kiddy Should chose

Lease Option

Laese option should be selected because it requires lower cash outflow over the life of asset.

Notes

1. First Installment is paid in Year 0 and will not be discounted.

2. Total 9 installments will be paid after first installment.

3. Since installments are paid in beginning of the year, discounting will start from 2nd installment with discounting factor of year 1.

4. A discounting factor explains the reduced value of money over time.

5. Please refer below given table for Discounting factor.

Discounting Factor table

Year

Value of rupee 1 after each year at 12% discount rate

Cumulative value

1

0.8929

0.8929

2

0.7972

1.6901

3

0.7118

2.4018

4

0.6355

3.0373

5

0.5674

3.6048

6

0.5066

4.1114

7

0.4523

4.5638

8

0.4039

4.9676

9

0.3606

5.3282

10

0.3220

5.6502

Calculation of Net Present value of Outflows
Buy Option
Year	Inflow (Outflow)	Present value factor at 12% discount rate	Discounted Inflow (Outflow)
0	$ (160,000.00)	1	$              (160,000.00)
1-10	$      (5,000.00)	5.6502	$                 (28,251.12)
10	$      10,000.00	0.3220	$                     3,219.73
Present value of Total Outflows	$              (185,031.38)
*$ 1000 is inflow in year 10 for sale of Machine