The XYZ Corporation is considering the purchase of a new milling machine for its

Question

The XYZ Corporation is considering the purchase of a new milling machine for its RH-widgets. The machinery is expected to cost $350,000 and last a total of 10 years having a salvage value of $20,000 for scrap at the end of its life. According to MACRS classification of machinery this asset should have a depreciable life of seven (7) years and this is the method of depreciation they want to use.

XYZ expects the machine to save the company about $95,000 per year in operating costs over the 10 years of its expected economic life. The require rate of interest (MARR) that ABC wants all investments to earn as a minimum is 10%.

ABC operates in a state that has a 6% state tax rate for a company earning what ABC does and ABC is in the 36% federal income tax rate level as well.

If XYZ does this they are thinking of borrowing 80% of the installed cost from 1st Federal at a rate of 8% for a period of 8 years (the loan would cost them 8% per year of the unpaid balance of the loan for 8 years).

If ABC decided to pay all the machine installed cost from internal funds and not borrow money for the machine, answer the following questions:

If ABC were to lease the machine for $85,000 per year would this be worthwhile?

Explanation / Answer

Solution:

If the machine is leased then we have to arrive at the present value of the leased amount

Present value of 10% for 10 years * 85000 = 6.1446 *85000 = $522,291

since the present value of the future lease cost is more than the actual purchase ocst of the machine hence leasing is not a viable option and should not be leased and hence purchase the asset.

Thank you.

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