Question

Super Sonics Entertainment is considering buying a machine that costs $435,000. The machine will be depreciated over five years by the straight-line method and will be worthless at that time. The company can lease the machine with year-end payments of $107,500. The company can issue bonds at a 9 percent interest rate. If the corporate tax rate is 35 percent, should the company buy or lease?

Answer 1

Company should lease the machine

Step-1:Calculation of present value of cash flow under leasing option
Year	After tax lease rental	Lost depreciation tax shield	Cash flow	Discount factor	Present Value
a	b	c	d=b+c	e=1.09^-a	f=d*e
1	$                     69,875.00	$                                                 30,450.00	$ 1,00,325.00	0.917431193	$      92,041.28
2	$                     69,875.00	$                                                 30,450.00	$ 1,00,325.00	0.841679993	$      84,441.55
3	$                     69,875.00	$                                                 30,450.00	$ 1,00,325.00	0.77218348	$      77,469.31
4	$                     69,875.00	$                                                 30,450.00	$ 1,00,325.00	0.708425211	$      71,072.76
5	$                     69,875.00	$                                                 30,450.00	$ 1,00,325.00	0.649931386	$      65,204.37
	Total				$   3,90,229.26
Working:
Depreciation expense	=	(Costs - Salvage Value)/Useful Life
	=	(435000-0)/5
	=	$ 87,000.00
Lost depreciation tax shield	=	Depreciation Expense	*	Tax rate
	=	$ 87,000.00	*	35%
	=	$ 30,450.00
After tax lease rental	=	Before tax lease rental	*	(1- Tax rate)
	=	$ 1,07,500.00	*	(1-0.35)
	=	$ 69,875.00
Step-2:Calculation of net advantage of leasing
Cost of Asset		$ 4,35,000.00
Present value of lease option		$ -3,90,229.26
Net advantage of leasing		$ 44,770.74
Since , net advantage of leasing is positive, company should lease the machine.