Question

Big Sky Mining Company must install $1.5 million of new machinery in its Nevada mine. It can obtain a bank loan for 100% of the purchase price, or it can lease the machinery. Assume that the following facts apply:

1. The machinery falls into the MACRS 3-year class. (The depreciation rates for Year 1 through Year 4 are equal to 0.3333, 0.4445, 0.1481, and 0.0741.)
2. Under either the lease or the purchase, Big Sky must pay for insurance, property taxes, and maintenance.
3. The firm's tax rate is 25%.
4. The loan would have an interest rate of 12%. It would be non amortizing, with only interest paid at the end of each year for four years and the principal repaid at Year 4.
5. The lease terms call for $400,000 payments at the end of each of the next 4 years.
6. Big Sky Mining has no use for the machine beyond the expiration of the lease, and the machine has an estimated residual value of $200,000 at the end of the 4th year.

1. What is the cost of owning? Enter your answer as a positive value. Do not round intermediate calculations. Write out your answer completely. For example, 5 million should be entered as 5,000,000. Round your answer to the nearest dollar.

   $   ?????

2. What is the cost of leasing? Enter your answer as a positive value. Do not round intermediate calculations. Write out your answer completely. For example, 5 million should be entered as 5,000,000. Round your answer to the nearest dollar.

   $   ?????

3. What is the NAL of the lease? Do not round intermediate calculations. Write out your answer completely. For example, 5 million should be entered as 5,000,000. Round your answer to the nearest dollar.

   $ ????

Answer 1

Answer a)

New Equipment cost		$15,00,000
New Equipment life		4
Equip. Residual Value		$2,00,000
Tax Rate		25%
Loan interest rate		12%
Annual rental charge		$4,00,000
After-tax cost of debt		9%	12%(1-25%)
Maintenance if not leased		$0
NPV LEASE ANALYSIS
Depreciation Rate			33.33%	44.45%	14.81%	7.41%
Depreciation Expense			4,99,950.00	6,66,750.00	2,22,150.00	1,11,150.00
BV at end of year			10,00,050.00	3,33,300.00	1,11,150.00	-
	Year =	0	1	2	3	4
Cost of Owning
Equipment cost		($15,00,000)
Loan amount		$15,00,000
Interest expense			($1,80,000)	($1,80,000)	($1,80,000)	($1,80,000)
Tax savings from interest			45000	45000	45000	45000
Principal repayment						($15,00,000)
After tax loan payment			($1,35,000)	($1,35,000)	($1,35,000)	($16,35,000)
Depreciation shield			$1,24,987.500	$1,66,687.500	$55,537.500	$27,787.500
Maintenance		$0	$0	$0	$0
Tax savings on maintenance		$0	$0	$0	$0	$0
Residual value						$2,00,000
Tax on residual value						($50,000)
Net cash flow		$0.000	($10,012.500)	$31,687.500	($79,462.500)	($14,57,212.500)
PV ownership cost @ 9%		($10,76,200.748)	NPV(9%,cash flows)+0

Answer b)

	Year =	0	1	2	3	4
Cost of Leasing
Lease payment			($4,00,000)	($4,00,000)	($4,00,000)	($4,00,000)
Tax savings from lease(@25%)			$1,00,000	$1,00,000	$1,00,000	$1,00,000
Net cash flow		$0	($3,00,000)	($3,00,000)	($3,00,000)	($3,00,000)
PV of leasing @ 9%		($9,71,915.963)	NPV(9%,cash flows)+0

Answer c)

Cost Comparison
PV of leasing @ 9%		($9,71,915.963)
PV ownership cost @ 9%		($10,76,200.748)
Net Advantage to Leasing		$1,04,284.785 = ($9,71,915.963)-($10,76,200.748)