Lease versus Purchase Decision. The Marijay Co. has selected a machine that will produce substantial cost savings over the next 5 years. The company can acquire the machine by outright purchase for $240,000 or a lease arrangement from the manufacturer.
Marijay could obtain a 5-year loan from a local bank to pay for the outright purchase. The bank would charge interest at an annual rate of 10 percent on the outstanding balance of the loan and require Marijay to maintain a compensating balance equal to 20 percent of the outstanding balance of the loan. The principal would be paid in five equal installments, and each annual payment of principal and interest would be due at the end of each year. In addition to borrowing the amount needed to purchase the machine, Marijay would have to obtain a loan to cover the compensating balance required by the local bank.
A local financier and investor heard of Marijay’s need and offered them an unusual proposition. She would advance the company $240,000 to purchase the machine if the company would agree to pay her a lump sum of $545,450 at the end of 5 years.
The capital lease offered by the manufacturer would allow all the tax benefits of ownership to accrue to Marijay. The title to the machine would be transferred to Marijay at the end of the 5 years at no cost. The manufacturer would be responsible for maintenance of the machine and has included $8,000 per year in the lease payment to cover the maintenance cost. Marijay would pay $70,175 to the manufacturer at the beginning of each year for 5-year period.
(a) Calculate the before-tax interest rate for each of the three alternatives.
(b) Without prejudice to your answer to (a), what arguments would you present to justify a lease financing alternative even if that arrangement turned out to have a higher interest cost than a regular loan?
(c) Compare the relative effect that the three financing alternatives would have on Marijay’s current ratio at the end of the first year. (CMA, adapted.)