The Hybee Company is evaluating an investment to produce a new product

The Hybee Company is evaluating an investment to produce a new product with an expected marketable life of 5 years. The expected annual net cash flow before tax is $120,000. To produce this product the company will have to acquire a new plant. The company can either purchase this plant or leave it. Details of these alternatives are as follows:

Purchase

The purchase price of the plant is $250,000 and it is expected that it will have a zero residual value after 5 years. The allowable annual depreciation charge on the plant is 20% per annum, straight-line.

Lease

The lease requires five annual payments, each of $60,000, payable at the beginning of each year. The company tax rate is 30 cents in the dollar. The required rate of return on the investment is 15% per annum after tax and the after-tax cost of an equivalent loan is 8% per annum.

Should the company undertake the investment? If so, should it purchase or lease the plant?

Here’s the SOLUTION

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