TVM 17 - Buy vs Lease Decision
The Campbell Company is considering either buying or leasing a manufacturing plant and is evaluating three alternatives. Option 1, purchase for a cash price of $675,000 with a useful life of 28 years. Option 2, lease for 28 years with annual lease payments of $72,000 at the beginning of the year. Option 3, purchase for $730,000 cash. The building is larger than needed and the company has the option of leasing the excess space for a net annual rental of $7,000 due at the end of each year.
Which option would you recommend assuming an interest rate of 11.4%?
Option number 1 is easy. The present value of $675,000 expended today is $675,000.
Option 2, this is a present value of an annuity due problem since payment occurs at the beginning of the year. We input the variables. The Rate is 11.4%. Number of periods, NPER, is 28. Payment, PMT is -72,000. And Type is 1. Next we look for the PV function. First we click on Rate, secondly we click on NPER, 28. We click on PMT -72,000 and we click on Type, 1. We hit OK. The PV is $669,339.
In Option 3, we determine the net present value. The cash purchase price is $730,000 and then we need to deduct the present value of the rental income. We do that by inputting the variables. The Rate is 11.4%. Number of periods, NPER, is 28. The payment, PMT, is -7,000. We look for the PV function. We click on Rate. We click on NPER. We click on PMT. We click OK. And the PV is 58,415. Now we deduct that from the cash purchase price and the net present value is $671,585.
Finally, we evaluate all three options. In looking at Option 2, we see it’s the lowest of the three options at $669,339 so that should be the option that the company chooses.