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Spot Co (Dec 13 – Amended)

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 1

The machine could be leased for an annual lease payment of $155,000 per year, payable at the start of each year.

Option 2

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.

Required:

A. Evaluate whether Spot Co should use leasing or borrowing as a source of finance, explaining the evaluation method which you use. (Ignore taxation).
B. Discuss the attractions of leasing as a source of both short-term and long-term finance.

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