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 OUHK Bank. Should Alpha Corporation change its buy or lease decision on the printing machine? Discuss.

c) Please comment on the following remark: ‘Leasing is a zero sum game between the lessee and lessor.’

d) Briefly discuss the reasons for firms to lease even if NALs are negative.

Answer 1

		After tax cost of borrowing =10*(1-0.35)=	6.50%
		Present Value (PV) of cash flow:
		(Cash flow)/((1+i)^N)
		i=discount rate =6.5%=0.065, N= Year of cash flow
		OPTION I-USING OWN RESERVE
		Annual depreciation =360000/5=	$72,000
		Annual depreciation tax shield =72000*35%=	$25,200
	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 Value of net Costs	$255,277
		OPTION II-BORROWING
		After tax annual cash flow =95000*(1-0.35)=	-$61,750
	N	YEAR	0	1	2	3	4	5
	CF	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 Value of net Costs	$256,613
		OPTIONI-USING OWN RESERVE IS RECOMMENDED
		Present Value of Net Costs is lower in OPTION-I
	b	If only $300,000 is borrowed :
		Annual interest expense =300000*10%=	$30,000
		After tax interest expense =30000*(1-0.35)=	$19,500
	N	YEAR	0	1	2	3	4	5
	A	Initial Cash Flow	($60,000)	$0	$0	$0	$0	$0
	B	Interest payment Cash Flow		-$19,500	-$19,500	-$19,500	-$19,500	-$19,500
	C	Principal Repayment						-$300,000
	D	Depreciation tax shield		$25,200	$25,200	$25,200	$25,200	$25,200
	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 Value of net Costs	$255,277
		It should still buy instead of leasing
	c	Leasing is a zero sum game between the lessee and lessor.’
		Only if conditions like effective interest rate and effective tax rates are same for the lessor and the lessee
		Often, the effective interest rate and tax rates are different , hence it is not a zero sum game
		Because of differentials , both parties may gain from a lease transaction
	d	REASONS FOR FIRMS TO LEASE:
		1. Effective tax rate may be beneficial
		2.Off balance sheet assets
		3.Lessor are often more capable of bearing residual value risk than the lessee
		4.Lessors are often more capable of maintaining the assets than the lessee