Question

The Lavish Carpet Manufacturing Co. has decided acquire a new machine that has an economic life of 10 years, with no residual value. The machine can be purchased for $75,000, and the supplier is willing to advance $45,000 of the purchase price at 12 percent. The loan is to be repaid in equal instalments over 10 years. Lavish Carpet pays 40 percent corporate income tax and can claim 20 percent capital cost allowances on the purchased asset. It expects to negotiate a further $30,000, 10-year loan with a financial institution at 14 percent interest, thereby financing any purchase entirely through debt. Meanwhile, Midland Leasing Ltd has also offered make the equipment available under a 10 year financial lease. Lease payments of $11,200 are to be paid at the end of each year. How should the asset be acquired?

Answer 1

The required rate of return is given. Let us assume it is 10%

Purchase option :

The present value of this option = present value of loan principal repayments + present value of interest payments - present value of interest tax shield - present value of depreciation tax shield

The loan payments, yearly depreciation, their tax shields, and the present value of tax shields are as below :

Interest in each year = (loan amount - cumulative principal repaid) * interest rate

interest tax shield = interest payment * tax rate

depreciation tax shield = depreciation * tax rate

NPV of purchase option is $49,119

Leasing option :

The NPV of leasing option is calculated using PV function in Excel with these inputs :

rate = 10%

nper = 10

pmt = 11,200 * (1 - 40%) (lease payments net of tax)

PV is calculated to be $41,291

The asset should be leased as the NPV of leasing option is lower than the NPV of purchasing option