High electricity costs have made Farmer Corporation”s chicken-plucking machine economically…

High electricity costs have made Farmer Corporation’s chicken-plucking machine economically worthless. There are only two machines available to replace it. The International Plucking Machine (IPM) model is available only on a lease basis. The annual, end-of-year payments are $2,100 for five years. This machine will save Farmer $6,000 per year through reductions in electricity costs in each of the five years. As an alternative, Farmer can purchase a more energy-efficient machine from Basic Machine Corporation (BMC) for $15,000. This machine will save $9,000 per year in electricity costs. A local bank has offered to finance the machine with a $15,000 loan. The interest rate on the loan will be 10 percent on the remaining balance and five annual principal payments of $3,000. Farmer has a target debt-to-asset ratio of 67 percent. Farmer is in the 34-percent tax bracket. After five years, both machines are worthless. Only straight-line depreciation is allowed for chicken-plucking machines. The savings that Farmer will enjoy are known with certainty, because Farmer has a long-term chicken purchase agreement with State Food Products, Inc., and a four-year backlog of orders.

a. Should Farmer lease the IPM machine or purchase the more efficient BMC machine?

b. Does your answer depend on the form of financing for direct purchase?

c. How much debt is displaced by this lease?

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