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Hello sir,
Spot Co is considering how to finance the acquisition of a machine costing $750,000 with an operating life of five years. There are two financing options.
Option A
The machine could be leased for an annual lease payment of $155,000 per year, payable at the start of each year.
Option B
The machine could be bought for $750,000 using a bank loan charging interest at an annual
rate of 7% per year. At the end of five years, the machine would have a scrap value of 10%
of the purchase price. If the machine is bought, maintenance costs of $20,000 per year
would be incurred.
Taxation must be ignored.Required:
Evaluate whether Spot Co should use leasing or borrowing as a source of finance.
My concern is:
In the solution, maintenance costs were used for the Buying case but I wonder why.What I know is that the lease looks like a Financial lease and so, maintenance costs would naturally fall to the Lessee.
If so, this would have the maintenance cost appear on both options and thus render it Irrelevant.
Could you please guide me to the grounds of using the cost?
The question specifically says that maintenance costs are incurred if the machine is bought. Therefore they are not incurred if the machine is leased – otherwise the question would have said so!
You cannot start assuming things that are not in the question 🙂
So the two machines could be of different qualities and still be compared without the question making it open?
I ask because I don’t get it that Buying incurs Maintenance cost but Leasing not and for the same machine.
That’s why I thought that even Leasing would incur costs but the question would be, On the Lessor or Lessee.
I have learnt though, so the machines can be similar but with different Maintenance costs just because they are leased and not bought?
Depending on the terms of the lease, maybe the lessor is responsible for the maintenance rather than the lessee (which is obviously the case here).
Again, the question makes it perfectly clear that the maintenance costs are only payable by the company if they buy the machine – not if they lease it. It is clearly an operating lease.
I am Sorry for my endless questions sir, but as you have said above, it depends on the terms of the lease and
since we have to be sure of retaining the machine for for five years, this would be a Finance lease and in it, Maintenance costs always fall to the Lessee.
I guess I have to follow your advice of a statement of the costs having been directed on to Buying.
But, I wonder if that is possible in the real world that costs would differ given the responsibilities of paying are on one party, merely for the sake of a Financing decision.
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