Question

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.

Answer 1

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