Question

It is time for the renewal of existing machinery at Blackstone Ltd. New machinery will cost $95,000 and this amount can be borrowed from the local bank at 8 percent interest with annual payments at the end of the year. The CCA rate on the machinery would be 20 percent. The machinery will be salvaged in 5 years for $22,000. The current machinery is worth $12,500. Blackstone could also lease the machinery with annual lease payments of $20,000 payable at the beginning of each year, which would avoid the annual maintenance expense of $1,250 involved if they purchase the machinery. Cost of capital is 13 percent. The tax rate is 40 percent.

Should Blackstone Ltd. lease or borrow to purchase the machinery?

Answer 1

Whenever we are presented with a case of lease or Buy(Borrow), we should calculate the NPV of the Cash Flow from both the cases.

When we compare the NPV of Cashflow in Borrow Vs Lease options we find the cashflow required for Lease ($ 47694) < Borrow($49350). Hence we Blackstone Ltd should go for Lease option. Refer the table below.

Solution	Year	0	1	2	3	4	5	NPV
Borrow
	Cost of Machine (a)	95000
	Salvage value of Current Machine (b)	12500
	Borrowed Capital ('c)= (a)-(b)	82,500
	Interest(d)= (d)*(c)	8%	6,600	6,600	6,600	6,600	6,600
	Annual Maintenace Cost		1,250	1,250	1,250	1,250	1,250
	CCA / Depreciation ('e) =(a)*(d)	20%	19,000	19,000	19,000	19,000	19,000
	Salvage value of New Machine(f)						-22,000
	Cash Flow (g)= (d)+('e)+(f)	82,500	26,850	26,850	26,850	26,850	4,850
	Tax Benefit (h)= (h)*((d)+('e)	40%	-10,740	-10,740	-10,740	-10,740	-10,740
	Net Cash flow		16,110	16,110	16,110	16,110	-5,890
	NVP of Cash flow	-	14,917	13,812	12,789	11,841	-4,009	49,350

Solution	Year		0	1	2	3	4	NPV
Lease
	Cost of Machine (a)	95000
	Salvage value of Current Machine (b)	12500
	Lease	20,000
	Cost Of Capital(d)= (d)*(c)	13%
	Lease		20,000	20,000	20,000	20,000	20,000
	Cash Flow (g)= (d)+('e)+(f)	20,000	20,000	20,000	20,000	20,000	20,000
	Tax Benefit (h)= (h)*((d)+('e)	40%	-8,000	-8,000	-8,000	-8,000	-8,000
	Net Cash flow(Cost of Capital)		12,000	12,000	12,000	12,000	12,000
	NVP of Cash flow	-	12,000	10,619	9,398	8,317	7,360	47,694

Thanks you.