Kiddy Toy Corporation needs to acquire the use of a machine to be used in its manufacturing process. The machine needed is manufactured by Lollie Corp. The machine can be used for 10 years and then sold for $11,000 at the end of its useful life. Lollie has presented Kiddy with the following options:
1. Buy machine. The machine could be purchased for $190,000 in cash. All maintenance and insurance costs, which approximate $5,000 per year, would be paid by Kiddy.
2. Lease machine. The machine could be leased for a 10-year period for an annual lease payment of $25,000 with the first payment due immediately. All maintenance and insurance costs will be paid for by the Lollie Corp. and the machine will revert back to Lollie at the end of the 10-year period.
Required:
Assuming that a 12 % interest rate properly reflects the time value of money in this situation and that all maintenance and insurance costs are paid at the end of each year, determine which option Kiddy should choose. Ignore income tax considerations.
Round all PV factors to 5 decimal places if you use the PV tables, and calculation to the nearest whole dollar. A negative sign should be used instead of parentheses.
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machine (debit)
maintenance and insurance Expense. (debit)
cash (credit)With 195000
9779
To determine which option Kiddy should choose, we need to calculate the present value (PV) of each option and compare them.
Option 1: Buy machine
The cash outflow is $190,000 upfront plus the annual maintenance and insurance costs of $5,000 per year for 10 years. The salvage value of $11,000 at the end of the 10-year period is not relevant for this calculation.
To calculate the PV of the cash outflows, we can use the PV of an annuity formula:
PV = PMT × [(1 - (1 + r)^-n) / r]
Where:
PMT = Annual maintenance and insurance cost = $5,000
r = Interest rate = 12% = 0.12
n = Number of periods = 10 years
PV = $5,000 × [(1 - (1 + 0.12)^-10) / 0.12]
PV ≈ $5,000 × (6.7894 / 0.12)
PV ≈ $5,000 × 56.5787
PV ≈ $282,893
The PV of Option 1 (buying the machine) is approximately $282,893.
Option 2: Lease machine
The cash outflow for this option is the annual lease payment of $25,000 for 10 years. There is no upfront cost or salvage value to consider.
Again, we can use the PV of an annuity formula to calculate the PV:
PV = PMT × [(1 - (1 + r)^-n) / r]
Where:
PMT = Annual lease payment = $25,000
r = Interest rate = 12% = 0.12
n = Number of periods = 10 years
PV = $25,000 × [(1 - (1 + 0.12)^-10) / 0.12]
PV ≈ $25,000 × (6.7894 / 0.12)
PV ≈ $25,000 × 56.5787
PV ≈ $1,414,468
The PV of Option 2 (leasing the machine) is approximately $1,414,468.
Conclusion:
Comparing the PV of Option 1 ($282,893) with the PV of Option 2 ($1,414,468), we can see that Option 1 is the more favorable choice for Kiddy Toy Corporation. Therefore, Kiddy should choose to buy the machine rather than leasing it.