Question

LEASE VERSUS BUY Morris-Meyer Mining Company must install $1.5 million of new machinery in its Nevada mine. It can obtain a bank loan for 100% of the required amount. Alternatively, a Nevada investment banking firm that represents a group of investors believes that it can arrange for a lease financing plan. Assume that the following facts apply: The equipment falls in the MACRS 3-year class. The applicable MACRS rates are 33%, 45%, 15%, and 7%.

2. Estimated maintenance expenses are $75,000 per year.

3. Morris-Meyer’s federal-plus-state tax rate is 40%.

4. If the money is borrowed, the bank loan will be at a rate of 15%, amortized in 4 equal installments to be paid at the end of each year.

5. The tentative lease terms call for end-of-year payments of $400,000 per year for 4 years.

6. Under the proposed lease terms, the lessee must pay for insurance, property taxes, and maintenance.

7. The equipment has an estimated salvage value of $400,000, which is the expected market value after 4 years, at which time Morris-Meyer plans to replace the equipment regardless of whether the firm leases or purchases it. The best estimate for the salvage value is $400,000, but it may be much higher or lower under certain circumstances.

To assist management in making the proper lease-versus-buy decision, you are asked to answer the following questions.

a. Assuming that the lease can be arranged, should Morris-Meyer lease or borrow and buy the equipment? Explain.

b. Consider the $400,000 estimated salvage value. Is it appropriate to discount it at the same rate as the other cash flows? What about the other cash flows—are they all equally risky? Explain.

Answer 1

a)	NAL OF LEASING:
1)	NPV OF BUYING:
	Annual installments of the loan = 1500000*0.15*1.15^4/(1.15^4-1) =	525398
	Interest rate for discounting = 15*(1-40%) =	9.00%
		0	1	2	3	4
	Beginning balance of loan		1500000	1199602	854144	456868
	Interest at 15%		225000	179940	128122	68530
	Total		1725000	1379542	982266	525398
	Installment		525398	525398	525398	525398
	Ending balance		1199602	854144	456868	0
	Depreciation under MACRS		495000	675000	225000	105000
	Cash flows of buying:
	Principal repayment		-300398	-345458	-397276	-456868
	After tax interest [Interest * (1-40%)]		-135000	-107964	-76873	-41118
	After tax salvage value = 400000*(1-40%)					240000
	Tax shield on depreciation		198000	270000	90000	42000
	After tax cash flows from buying		-237398	-183422	-384149	-215986
	PVIF at 9.0% [PVIF = 1/1.0924^n]		0.91743	0.91743	0.91743	0.91743
	PV at 9.0%		-217796	-168277	-352431	-198152
	NPV of buying	-936656
2)	NPV OF LEASING:
	After tax lease payments = 400000*(1-40%) =	-240000
	NPV of leasing = -240000*(1.09^4-1)/(0.09*1.09^4) =	-777533
3)	NAL OF LEASING = -777533-(-936656) =	159123
	NOTE:
	Maintenance expenses have been excluded from both options as they are payable in either case.
	RECOMMENDATION:
	As the NAL of the lease is positive, leasing would be advantageous.
b)	The capital expenditure decision to purchase the equipment is already taken, Now
	it is to be decided whether it is to be leased or bought by borrowing the required
	funds. Hence, all the cash flows can be discounted with the same rate, which is the
	after tax cost of debt.