Emerson Corp. is trying to decide whether to lease or purchase a piece of equipment needed for the next five years. The equipment would cost $500,000 to purchase, and maintenance costs would be $20,000 per year. After five years, Emerson estimates it could sell the equipment for $100,000. If Emerson leases the equipment, it would pay $150,000 each year, which would include all maintenance costs. Emerson's hurdle rate is 12%.a. What is the net present value of the cost of purchasing the equipment?b. What is the net present value of the cost of leasing the equipment?c. Based on financial factors, should Emerson purchase or lease the equipment? Why?
What will be an ideal response?
a. $515,356 = $500,000 + ($20,000 × 3.6048) ? ($100,000 × 0.5674)
b. $540,720 = $150,000 × 3.6048
c. Purchase; the net present value of the cost is lower.
Net present value is calculated by discounting the annual cash flows and subtracting the initial investment. The alternative with the lower cost in net present value terms should be chosen.
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