Question

Karuda Transportation Sdn Bhd provides bonded trucking services to its clients. The company is evaluating a potential lease arrangement on a truck that cost $250,000 and falls into the MACRS 5-year class. The applicable MACRS depreciation rates are 20%, 32%, 19%, 12%, 11% and 6%. Karuda has a ready credit line from their banker, a term loan financing with an attractive rate of 10% p.a. if they decided to borrow money and buy the asset rather than lease it. The 5-equal instalments are to be paid at the end of each year.

The truck is expected to have a 5-year economic life, and its estimated residual value is $25,000. If Karuda buys the truck, it would purchase a maintenance contract with the Vendor, Scandia Truck & Bus Sdn Bhd that costs $6,000 per year, payable at the end of each year. Karuda plans to keep the truck and use it beyond its recovery period.

Karuda is also required to insure the trucks and the annual insurance premium is calculated at a rate of 1.75% of the insured value. For the first year, the truck is insured for $250,000. For the subsequent years, the book value of the asset is taken as the yearly insured value. Annual insurance premium are being paid at the beginning of the year.

The lease option calls for $60,000 lease payment, payable in advance. All other costs will be borne by the lessor. The company intends to exercise its option to purchase the truck at the end of the lease period for $12,000. Karuda’s tax rate is 30 percent.

1. Calculate the after-tax cash flows associated with each of the alternative.
2. What is the Net Advantage to Leasing? Should the firm lease or buy?

Answer 1

New Equipment cost		$2,50,000
New Equipment life		5
Equip. Residual Value		$25,000
Tax Rate		30%
Loan interest rate		10%
Annual rental charge		$60,000
After-tax cost of debt		7%
Maintenance if not leased		$6,000

NPV LEASE ANALYSIS
Depreciation Rate			20.00%	32.00%	19.00%	12.00%	11%	6%
Depreciation Expense			50,000.00	80,000.00	47,500.00	30,000.00	27,500.00	15,000.00
BV at end of year			2,00,000.00	1,20,000.00	72,500.00	42,500.00	15,000.00	-
	Year =	0	1	2	3	4	5	6
Cost of Owning
Equipment cost		($2,50,000)
Loan amount		$2,50,000
loan repayment expense			($65,949)	($65,949)	($65,949)	($65,949)	($65,949)	($65,949)
Tax savings from interest			19784.811	19784.811	19784.811	19784.811	19784.811	19784.811
Principal repayment
After tax loan payment			($46,165)	($46,165)	($46,165)	($46,165)	($46,165)	($46,165)
Depreciation shield			$15,000.000	$24,000.000	$14,250.000	$9,000.000
Maintenance			($6,000)	($6,000)	($6,000)	($6,000)	($6,000)
insurance		($4,375)	($3,500)	($2,100)	($1,269)	($744)	($263)
Tax savings on maintenance and insurance		$1,313	$2,850	$2,430	$2,181	$2,023	$1,879	$0
Residual value							$25,000
Tax on residual value							($7,500)
Net cash flow		($3,062.500)	($37,814.559)	($27,834.559)	($37,002.684)	($41,885.184)	($33,048.309)	($46,164.559)
PV ownership cost @ 7%		($1,79,198.592)

	Year =	0	1	2	3	4	5
Cost of Leasing
Lease payment		($60,000)	($60,000)	($60,000)	($60,000)	($60,000)
Tax savings from lease		$18,000	$18,000	$18,000	$18,000	$18,000
Net cash flow		($42,000)	($42,000)	($42,000)	($42,000)	($42,000)
PV of leasing @ 7%		($1,84,262.873)

BUY
because the net advantage of leasing is				($5,064.28)