Question

In: Finance

Mercy Medical Mega Center , a taxpaying entity, has made the decision to purchase a new...

  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?


Solutions

Expert Solution

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.

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