Question
In: Finance
Lease versus purchase JLB Corporation is attempting to determine whether to lease or purchase research equipment....
Lease versus purchase JLB Corporation is attempting
to determine whether to lease or purchase research
equipment.
The firm is in the 21% tax bracket, and its after-tax
cost of debt is currently 8%. The terms of the lease and of the
purchase are as follows:
Lease Annual end-of-year lease payments of $25,200 are
required over the 3-year life of the lease. All maintenance costs
will be paid by the lessor; insurance and other costs will be borne
by the lessee. The lessee will exercise its option to purchase the
asset for $5,000 at termination of the lease.
Purchase The research equipment, costing $60,000, can be financed entirely with a 14% loan requiring annual end-of-year payments of $25,844 for 3 years. The firm in this case will depreciate the equipment under MACRS using a 3-year recovery period. (See Table 4.2 for the applicable depreciation percentages.) The firm will pay $1,800 per year for a service contract that covers all maintenance costs; insurance and other costs will be borne by the firm. The firm plans to keep the equipment and use it beyond its 3-year recovery period.
a) Calculate the after-tax cash outflows associated
with each alternative
b) Calculate the present value of each outflow stream,
using the after tax cost of debt.
c) Which alternative-lease or purchase-would you recommend? Why?
please show the work from a to z.
Solutions
Expert Solution
a)
| Lease after tax cash flow | |||
| Particulars | Year 1 | Year 2 | Year 3 |
| Cash outflow | $ 25,200.00 | $ 25,200.00 | $ 25,200.00 |
| Tax Saving @21% | $ 5,292.00 | $ 5,292.00 | $ 5,292.00 |
| After Tax Cash Outflow | $ 19,908.00 | $ 19,908.00 | $ 19,908.00 |
| Asset Purchase | $ - | $ - | $ 5,000.00 |
| Total After Tax Cash Outflow | $ 19,908.00 | $ 19,908.00 | $ 24,908.00 |
Purchase after tax cash flow
| Working Note-1: Segregating Loan installment to Principal and Interest | ||||
| Year | Opening Bal | Payment | Interest @14% | Principal |
| 1 | $ 60,000.00 | $ 25,844.00 | $ 8,400.00 | $ 17,444.00 |
| 2 | $ 42,556.00 | $ 25,844.00 | $ 5,957.84 | $ 19,886.16 |
| 3 | $ 22,669.84 | $ 25,844.00 | $ 3,173.78 | $ 22,670.22 |
| Working Note-2: Depreciation Tax Shield | ||
| Year | Depreciation | Tax Shield |
| 1 | $ 19,800.00 | $ 4,158.00 |
| 2 | $ 27,000.00 | $ 5,670.00 |
| 3 | $ 9,000.00 | $ 1,890.00 |
| Computation of After Tax Cash Outflow | |||
| Particulars | Year 1 | Year 2 | Year 3 |
| Payment | $ 25,844.00 | $ 25,844.00 | $ 25,844.00 |
| Less: Interest Tax Shield | $ (1,764.00) | $ (1,250.97) | $ (666.33) |
| Less: Depreciation tax Shield | $ (4,158.00) | $ (5,670.00) | $ (1,890.00) |
| After Tax Maintenance | $ 1,422.00 | $ 1,422.00 | $ 1,422.00 |
| After Tax Cash Flow | $ 21,344.00 | $ 20,345.03 | $ 24,709.67 |
b)
| Computation of Present Value of After Tax Cash Outflow for both the alternatives | ||||||
| Year | Lease | PV @8% | PV of Lease Payments | Purchase | PV @8% | PV of Purchase Cash Flows |
| 1 | $ 19,908.00 | $ 0.9259 | $ 18,433.33 | 21,344.00 | $ 0.9259 | $ 19,762.96 |
| 2 | $ 19,908.00 | $ 0.8573 | $ 17,067.90 | 20,345.03 | $ 0.8573 | $ 17,442.58 |
| 3 | $ 24,908.00 | $ 0.7938 | $ 19,772.77 | 24,709.67 | $ 0.7938 | $ 19,615.33 |
| $ 55,274.01 | $ 56,820.88 | |||||
C)
It is better to go with Lease option since its involves less cash outflow compared to purchase option
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