In: Finance
The Randolph Limited has decided to acquire a new truck. One alternative is to lease the truck on a 4-year guideline contract for a lease payment of R10,000 per year, with payments to be made at the beginning of each year. The lease would include maintenance. Alternatively, Randolph Limited could purchase the truck outright for R40,000, financing the purchase by a bank loan for the net purchase price and amortizing the loan over a 4-year period at an interest rate of 10% per year. Under the borrow-to-purchase arrangement, RTC would have to maintain the truck at a cost of R1,000 per year, payable at year end. The truck falls into the MACRS 3-year class. It has a residual value of R10,000, which is the expected market value after 4 years, when Randolph Ltd plans to replace the truck irrespective of whether it leases or buys. Randolph Limited has a marginal tax rate of 40%.
Required
1.1 What is Randolph’s Present Value cost of leasing?
1.2 What is Randolph’s Present Value cost of owning? Should the truck be leased or purchased?
1.1]
PV of leasing = present value of after-tax lease payments
After tax lease payment = lease payment * (1 - tax rate) = $10,000 * (1 - 40%) = $6,000
For calculating present value, discount rate used is 10%, which is the interest rate on loan
PV of leasing = ($6,000 / (1 + 10%)0) + ($6,000 / (1 + 10%)1) + ($6,000 / (1 + 10%)2) + ($6,000 / (1 + 10%)3)
PV of leasing = $20,921
1.2]
PV of owning = PV of each year's cash flow
Each year's cash flow = loan payments - interest tax shield - depreciation tax shield + maintenance costs
In year 4, after-tax residual value is added to that year's cash flow
The loan principal is assumed to be repaid in 4 years, with 25% principal in each year. Interest in each year = principal outstanding * interest rate
depreciation tax shield = depreciation amount * tax rate
interest tax shield = interest amount * tax rate
after-tax residual value = residual value * (1 - tax rate) = $10,000 * (1 - 40%) = $6,000
Discount factor for each year = 1 / (1 + 10%)year
Present value of cash flows = $30,632
PV of owning is $30,632
Leasing is recommended as the PV of leasing is lower