Question

Suppose a company wants to decide whether to lease or purchase an asset.

Purchase: The capital cost required to purchase the asset is $1,000,000 (at time zero) with a salvage value of $500,000 at the end of the 5th year. The purchased asset can be depreciated based on MACRS 5-year life depreciation with the half year convention (table A-1 at IRS (https://www.irs.gov/publications/p946) over six years (from year 0 to year 5).

Lease: The asset can be leased for 5 years and annual operating lease payments (LP) of $250,000 (from year 1 to year 5).

The asset would yield the annual revenue of $350,000 for five years (from year 1 to year 5) and operating cost of $60,000 for year 1 to 5.

Considering income tax of 35% and minimum ROR of 16%, calculate the ATCF and NPV for both alternatives and conclude which alternative is a better decision.

Answer 1

Present value = FV / (1+r)^n

where FV = future value

r = rate of return in this case 16%

and n = no of years

In case, the asset is leased, the inflow will be 350000 per year and outflow will be 60000 of exenses and 250000 operating lease instalment. So income tax will be 350000 - 60000 - 250000 for each year at the rate of 35%. After this we get the after tax cash flows.Discounting them as per the year and the rate of 16% we get a total NPV of 85131.63

In case of purchase, we will be paying 1,000,000 out front at year 0. Inflow will be of 350000 each year and outflow of 60000 each year. As per the depreciation rates of table A-1, we can calculate the depreication each year. Depreciation will be (Cost value - Salvage value) x % rate for that year. Income tax will be net inflow - Depreciation x 35%. And cash flow will be Inflow - Outflow + Depreciation - Income tax. Discounting this with 16%, we get a NPV of 183,220.83

Since the NPV in purchase value is better than leasing, the better decision is to buy the equipment.