Question

1. Mercy Medical Mega Center , a taxpaying entity, has made the decision to purchase a new laser surgical device. The device costs $400,000 and will be depreciated on straight-line basis over five years to a zero salvage value. Mercy Medical could borrow the full amount at a 15 percent rate for five years. The after-tax cost of debt equals 9 percent. Alternatively, it could lease the device for five years. The before-tax lease payments per year would be $80,000. The tax rate for this MegaCenter is 40 percent. From a financial perspective, should Mercy lease the surgical device or borrow the money to purchase it and why?

Answer 1

Step-1:Calculation of present value of cash flows under lease option
Year	Before tax lease rentals	After tax lease rentals	Lost depreciation tax shield	Total Cash flow	Discount factor	Present value
x	a	b=a*(1-0.40)	c	d=b+c	e=1.09^-x	f=d*e
1	$ 80,000.00	$ 48,000.00	$ 32,000.00	$     80,000.00	0.917431	$     73,394.50
2	$ 80,000.00	$ 48,000.00	$ 32,000.00	$     80,000.00	0.84168	$     67,334.40
3	$ 80,000.00	$ 48,000.00	$ 32,000.00	$     80,000.00	0.772183	$     61,774.68
4	$ 80,000.00	$ 48,000.00	$ 32,000.00	$     80,000.00	0.708425	$     56,674.02
5	$ 80,000.00	$ 48,000.00	$ 32,000.00	$     80,000.00	0.649931	$     51,994.51
Total						$ 3,11,172.10
Working:
Depreciation under straigt line method	=	(Cost - Salvage value)/Useful life
	=	(400000-0)/5
	=	$ 80,000.00
Lost depreciation tax shield	=	Depreciation expense	*	Tax rate
	=	$ 80,000.00	*	40%
	=	$ 32,000.00
Step-2:Calculation of net advantage to lease
Cost of device				$ 4,00,000.00
Less present value of cash flow under lease option				$ 3,11,172.10
Net Advantage to Lease				$     88,827.90
Net Advantage to lease is positive .So ,it is beneficial to lease device than to buy the device.