Question

Potential Answers :

A.

1) -$645,656; 2) -$661,653; 3) Buy

B.

1) -$591,793; 2) -$661,653; 3) Buy

C.	1) -$591,793; 2) -$550,952; 3) Lease

D.

1) -$607,696; 2) -$550,952; 3) Lease

An equipment costs $1,000,000, the loan rate on the equipment is 10%, and the marginal tax rate is 40%. Assume that the equipment will have 3-year MACRS life but will be used for four years (with the annual depreciation rates of 33.33% the first year, 44.5% the second year, 14.75% the third year, and 7.5% the fourth year). If the company borrows and buys, assume that it can obtain a maintenance contract at a cost of $20,000 per year. The equipment will have a residual value of $ $200,000 at the end of year 4. Assume that the firm can lease the equipment, instead of borrowing and buying it, at a cost of $250,000 per year. Please answer the following questions: 1) What is the present value of the cost of owning? 2) What is the present value of the cost of leasing? 3) Should the firm buy or lease the equipment?

Answer 1

Year	Cost of Assets	Depreciation	Depreciation	Tax saving @ 40%
1	1,000,000	33.33%	333,300	133,320
2	1,000,000	44.50%	445,000	178,000
3	1,000,000	14.75%	147,500	59,000
4	1,000,000	7.50%	74,200	29,680
			1,000,000	400,000
WDV	-
Sale value	200,000
Loss/(Gain)	(200,000)
Tax saving	(80,000.00)
After tax salvage value	120,000.00
After tax annual cost of buying
Year	Maintenance	Interest payment	Tax saving on Maintenance & interest	Tax saving on Depreciation	Total cost
0	-		-	-	-
1	20,000	100,000	(48,000)	(133,320)	(61,320)
2	20,000	100,000	(48,000)	(178,000)	(106,000)
3	20,000	100,000	(48,000)	(59,000)	13,000
4	20,000	100,000	(48,000)	(29,680)	42,320
Assumed that the loan will be repaid at the end of 4 years
After tax annual cost of leasing
Year	Maintenance	Tax saving on lease payments	Tax saving on Depreciation	Total cost
0	-	-	-	-
1	250,000	(100,000)	-	150,000
2	250,000	(100,000)	-	150,000
3	250,000	(100,000)	-	150,000
4	250,000	(100,000)	-	150,000
PV of cost of owning
Year	Cost	Buying	Net cash flow of owning	PV factor @ 10%	PV
0		-	-	1.000	-
1	-	(61,320)	(61,320)	0.909	(55,745)
2	-	(106,000)	(106,000)	0.826	(87,603)
3	-	13,000	13,000	0.751	9,767
4	-	42,320	42,320	0.683	28,905
4	1,000,000	(120,000)	880,000	0.683	601,052
				Net present value	496,375
PV of cost of leasing
Year	Cost	Buying	Net cash flow of owning	PV factor @ 10%	PV
0		-	-	1.000	-
1	-	150,000	150,000	0.909	136,364
2	-	150,000	150,000	0.826	123,967
3	-	150,000	150,000	0.751	112,697
4	-	150,000	150,000	0.683	102,452
				Net present value	475,480
Since PV of leaseing is less and hence it is recommended to lease