Question

AFX Sdn Bhd is trying to decide whether to accept a business loan or a lease financing
facility for an equipment purchase. The equipment cost $60,000 with 3-year economic life,
depreciated annually based on MACRS 3-year class with the following rates: Year 1 = 33%;
Year 2 = 45%; Year 3 = 15%; Year 4 = 7%.
If AFX accepts the business loan option, the 3-year loan will attract an interest rate at 12%
interest calculated on a yearly reducing balance. AFX would have to maintain the equipment
with an annual maintenance fee of $4,000, payable after services have been rendered.
Annual insurance premium is $1,400 on cash before cover basis. AFX is planing to sell the
equipment after its useful life for $3,000.
Should AFX opt for lease financing, the annual lease rental to be paid in advance is
$21,000. You also intend to exercise the option to purchase the equipment for $6,000 at the
end of the lease period. Your company’s tax rate is 35%. Company’s after-tax cost of debt is
8%.
Which option should the company choose, lease or purchase? Explain.

Answer 1

I) Schedule of cash outflows: Leasing alternative

End of Year (i)	Lease payment (ii)	Tax shield on cash outflows (iii) = (ii * 35%)	After tax cash outflows (iv) = (ii - iii)	PVF @ 8% (v)	Present value of lease payment (iv*v)
0	21,000	0	21,000	1	21,000.000
1	21,000	7,350	13,650	0.9259	12,638.535
2	21,000	7,350	13,650	0.8573	11,702.145
3	6,000	9,450	-3,450	0.7938	-2,738.610
					42,602.070

II) Schedule of debt payment:

Annual payment = Principal*interest rate*[(1+interest rate)^loan period]/{[(1+interest rate)^loan period]-1} = 60000*12%*[(1+0.12)^3]/{[(1+0.12)^3]-1} = 7200*(1.12^3)/[(1.12^3)-1] = 7200*1.404928/0.404928 = 24,981

End of year	Principal amount owing at the beginning of the year	Annual interest @ 12%	Annual payment	Principal amount owing at the end of the year
1	60,000	7,200	24,981	42,219
2	42,219	5,066	24,981	22,304
3	22,304	2,677	24,981	0
		14,943

III) Schedule of cash outflows: Debt financing

End of year (i)	Annual payment (ii)	Annual interest @ 12% (iii)	Depreciation (iv)	Annual Maintenance (v)	Annual insurance premium (vi)	Tax shield (vii) = (iii+ iv+v+vi) *35%	Net cash outflows (viii) = (ii+v+ vi-vii)	PVF @ 8% (ix)	Present value of cashflows (viii) = (vi*vii)
0					1,400	490	910	1	910.00
1	24,981	7,200	19,800	4,000	1,400	11,340	19,041	0.9259	17,630.06
2	24,981	5,066	27,000	4,000	1,400	13,113	17,267.90	0.8573	14,803.77
3	24,981	2,677	6,000	4,000		4,437	24,544.05	0.7938	19,483.07
4			4,200			1,470	-1,470	0.7350	-1,080.45
									51,746.45

Net advantage of Leasing = Present value of cost of owning - Present value of leasing = 51,746.45 - 42,602.07 = 9,144.38

Working Note: 1.Depreciation:

Depreciation for year 1 = cost * 33% = 60000*33% = 19,800

Depreciation for year 2 = cost * 45% = 60000*45% = 27,000

Depreciation for year 3 = cost * 15% = 60000*15% = 9,000

Net depreciation for year 3 = Depreciation - sale value = 9,000 -3,000 = 6,000

Depreciation for year 4 = cost * 7% = 60000*7% = 4,200

Since cost of purchase is more than cost of leasing, hence leasing option is better.