Question

Jane is the financial manager for Alpha Corporation. She has been asked to perform a lease-versus-purchase analysis on a new printing machine.

The machine costs $360,000 and will be depreciated using the straightline method with zero residual value over five years. Alternatively, the company

can lease the machine with year-end payments of $95,000 over five years. The company’s tax rate is 35% and its before-tax cost of borrowing is 10%.

Required:

a Given the above information, calculate the net advantage to leasing (NAL) for Alpha Corporation to obtain the new printing machine,

assuming the company will use its own reserves rather than borrowing from the bank. Which option would you recommend? Explain.

b Suppose only $300,000 purchase price of the machine is borrowed from ABC Bank. Should Alpha Corporation change its buy or lease decision

on the printing machine? Discuss.

Answer 1

		Present Value =(Cash Flow)/((1+i)^N)
		i=discount rate =after tax cost of borrowing =10*(1-0.35)=				0.065
		N=Year of cash flow
	a.	ANALYSIS OF PURCHASE ALTERNATIVE
		Annual Depreciation	$72,000	(360000/5)
		Depreciation tax shield	$25,200	(72000*35%)
	N	Year	0	1	2	3	4	5
	CF	Cash Flow	($360,000)	$25,200	$25,200	$25,200	$25,200	$25,200	SUM
	PV=CF/(1.065^N)	Present Value of Cash Flow	($360,000)	$23,662	$22,218	$20,862	$19,589	$18,393	($255,277)
		Present worth of Costs	$255,277
		ANALYSIS OF LEASE OPTION
		After tax Cash flow for lease	$61,750	(95000*(1-0.35)
	N	Year	0	1	2	3	4	5
	CF	After Tax Cash Flow	$0	-$61,750	-$61,750	-$61,750	-$61,750	-$61,750	SUM
	PV=CF/(1.065^N)	Present Value of Cash Flow	$0	-$57,981	-$54,442	-$51,120	-$48,000	-$45,070	($256,613)
		Present worth of Costs	$256,613
		PURCHASE OPTION IS RECOMMENDED
		Present Worth of costs is lower for Purchase Option
	b	If $300000 is borrowed to purchase
		Initial Cash Flow	($60,000)	(360000-300000)
		Annual interest cost (Before tax)	$30,000	(300000*10%)
		After tax interest cost =30000*(1-0.35)	$19,500
	N	Year	0	1	2	3	4	5
	A	Initial Cash Flow	($60,000)
	B	Annual interest cost		-$19,500	-$19,500	-$19,500	-$19,500	-$19,500
	C	Annual Depreciation tax shield		$25,200	$25,200	$25,200	$25,200	$25,200
	D	Terminal Principal Payment						-$300,000
	CF=A+B+C+D	Net Cash Flow	($60,000)	$5,700	$5,700	$5,700	$5,700	-$294,300	SUM
	PV=CF/(1.065^N)	Present Value of Cash Flow	($60,000)	$5,352	$5,025	$4,719	$4,431	-$214,804	($255,277)
		Present worth of Costs	$255,277
		PURCHASE OPTION IS RECOMMENDED
		Present Worth of costs is lower for Purchase Option