The management of The Alexandrov Company decided to acquire the use of a machine to be used in its manufacturing process. The machine is manufactured only by Chang, Incorporated. The machine would have a useful life of ten years and would then be sold for $10,000 at the end of its useful life. Chang’s management has presented Alexandrov with the following acquisition options:

Lease: The machine could be leased for an eight-year period for an annual lease payment of $25,000, with the first payment due on the date that the agreement is signed. Related annual executory costs (maintenance and insurance expenses for the machine), which are expected to be about $5,000 per year, would be paid by Alexandrov.

Purchase: The machine could be purchased for $130,000 in cash. The related maintenance and insurance costs would also become the additional responsibility of Alexandrov.

Assume that (1) Alexandrov and Chang will agree on a transaction on November 30, 2020; and (2) the current interest rate for Alexandrov’s lease arrangements is 12%, but the rate applicable to annual maintenance and insurance expenses is only 8%.

Prepare a schedule showing the alternatives available to The Alexandrov Company for the acquisition of the equipment.

Solution and Explanation:

Calculation of present value of Lease payments

Year  Amount        PV factor at 12%  Present Value

Year 0  25,000.00           1                 25,000.00

Year 1  25,000.00  0.892857143       22,321.43

Year 2  25,000.00  0.797193878       19,929.85

Year 3  25,000.00  0.711780248       17,794.51

Year 4  25,000.00  0.635518078       15,887.95

Year 5  25,000.00  0.567426856      14,185.67

Year 6  25,000.00  0.506631121       12,665.78

Year 7  25,000.00  0.452349215       11,308.73

Year 8  25,000.00  0.403883228  10,097.08

Year 9  25,000.00  0.360610025       9,015.25

Present value of lease payments  158,206.24

Note: The amount is paid at the beginning of month.

Calculation of present value of cash outflows if machine is purchased:

where: MIC - Maintenance and Insurance costs, SV - Salvage value

Year  Machn Cost  MICSV  Total  PV factor at 12%  Present Value

Year 0  130,000.00  -        130,000.00         1.00             130,000.00

Year 1                 5,000.00 5,000.00  0.892857143          4,464.29

Year 2                 5,000.00 5,000.00  0.797193878           3,985.97

Year 3                 5,000.00 5,000.00  0.711780248           3,558.90

Year 4                  5,000.00 5,000.00  0.635518078           3,177.59

Year 5                   5,000.00 5,000.00  0.567426856    2,837.13

Year 6                   5,000.00 5,000.00  0.506631121           2,533.16

Year 7                   5,000.00 5,000.00  0.452349215           2,261.75

Year 8                    5,000.005,000.00  0.403883228    2,019.42

Year 9                   5,000.00 5,000.00  0.360610025     1,803.05

Year 10                    5,000.00 (10,000.00) (5,000.00) 0.321973237(1,609.87)

Present value of cash outflows                            155,031.38

Savings                                                                                                3,174.86

The Present value of cash outflows us less if machine is purchase rather than taking it on lease.

So it is economical for Alexandrov to buy machine as it will save $ 3,174.86.

answer; capital structure decision;

answer; measurable outcome;