Question

Howell Auto Parts is considering whether to borrow funds and purchase an asset or to lease the asset under an operating lease arrangement. If the company purchases the asset, the cost will be \(10,000. It can borrow funds for four years at 12 percent interest. The firm will use the three-year MACRS depreciation category (with the associated four-year write-off). Assume a tax rate of 35 percent.

The other alternative is to sign two operating leases, one with payments of \)2,600 for the first two years, and the other with payments of $4,600 for the last two years. In your analysis, round all values to the nearest dollar.

g. Which alternative should be selected, based on minimizing the present value of after-tax costs?

Short answer

The borrow-purchase alternative should be selected as it has a lower cost than the leasing option.

Step-by-step solution

Information available

The present value of the after-tax cost of leasing = $7,585

The present value of the after-tax cost of borrow-purchase= $6,937

Decision regarding the selection of the alternative

The present value of the after-tax cost of the borrow-purchase option is less than the present value of the after-tax cost of the leasing alternative, so the organisation should select the borrow-purchase decision.