Praeda Inc. has the choice of buying a piece of equipment or leasing it. The purchase cost of the equipment will be $155,000. For tax purposes, the depreciation on the machine will be full, straight-line depreciation over 7 years. The machine will be used for 5 years, regardless of whether it is purchased or leased. The machine is expected to have a market value of $70,250 at the end of the 5 years. The lessor will require annual payments of $21,000. A total of 5 annual payments will be required under the lease contract, with the first payment due immediately (that is, at the start of the first year). The lease will be treated as an operating lease for tax and reporting purposes.
Praeda Inc. pays 6.25% interest on its loans, and its weighted average cost of capital is 8.75%. The company faces a marginal tax rate of 21%.
- What is the cost of leasing?
- What is the cost of borrowing?
- Should Praeda Inc. lease the machine, or should it buy the machine? You must explain your answer in order to get any credit.