Question

Big Sky Mining Company must install $1.5 million of new machinery in its Nevada
mine. It can obtain a bank loan for 100% of the purchase price, or it can lease the
machinery. Assume that the following facts apply.
(1) The machinery falls into the MACRS 3-year class.
(2) Under either the lease or the purchase, Big Sky must pay for insurance, property
taxes, and maintenance.
(3) The firm’s tax rate is 25%.
(4) The loan would have an interest rate of 15%. It would be nonamortizing, with only
interest paid at the end of each year for four years and the principal repaid at Year 4.
(5) The lease terms call for $400,000 payments at the end of each of the next 4 years.
(6) Big Sky Mining has no use for the machine beyond the expiration of the lease, and
the machine has an estimated residual value of $250,000 at the end of the 4th year.
a. What is the cost of owning?
b. What is the cost of leasing?
c. What is the NAL of the lease?

Answer 1

	Discount rate = After tax cost of debt = 15%*(1-25%) =	11.25%
a]		0	1	2	3	4
	Interest on loan at 15%		$        2,25,000	$    2,25,000	$     2,25,000	$         2,25,000
	Repayment of loan		$                     -	$                 -	$                  -	$      15,00,000
	MACRS depreciation		$        4,99,950	$    6,66,750	$     2,22,150	$         1,11,150
	Cash flows of owning:
	After tax interest = Interest expense*(1-25%)		$      -1,35,000	$   -1,35,000	$   -1,35,000	$       -1,35,000
	Repayment of principal [Installment-Interest]					$     -15,00,000
	Tax shield on depreciation = Depreciation*25% =		$        1,24,988	$    1,66,688	$        55,538	$            27,788
	After tax residual value = 250000*(1-25%) =		$                     -	$                 -	$                  -	$         1,87,500
	Cash flows of owning		$          -10,013	$        31,688	$       -79,463	$     -14,19,713
	PVIF at 11.25%	1	0.89888	0.80798	0.72627	0.65283
	PV at 11.25%		$            -9,000	$        25,603	$       -57,711	$       -9,26,831
	NPV of owning	$       -9,67,939
b]	PV cost of leasing = -400000*(1-25%)*(1.1125^4-1)/(0.1125*1.1125^4) =	$       -9,25,787
c]	NAL of leasing = -925787-(-967969) =	$ 42,152
	As the NAL of leasing is positive, the truck should be leased.