Question

Q3)      The Kam Steel Corporation is trying to decide whether to lease or buy a new production equipment. Management has already determined that acquisition of the system has a positive NPV. The system costs $375,000 and qualifies for a 25% CCA rate. The equipment will have a $95,000 salvage value in 5 years. Wildcat's tax rate is 36%, and the firm can borrow at 9%. Southtown Leasing Company has offered to lease the drilling equipment to Wildcat for payments of $35,000 per year. Southtown's policy is to require its lessees to make payments at the start of the year. Based on the given information, what is the NAL for Wildcat?

(8 Points)

Answer 1

Formula sheet

A	B	C	D	E	F	G	H	I	J
2
3
4		Cost of purchasing the equipment:
5
6		Depreciation each year can be calculated as follows:
7		Investment in the system	375000
8		Tax basis of the equipment (B)	=D7
9
10		CCA Rate	0.25
11		Hence depreciation each year can be calculated as follows:
12				Year 1	Year 2	Year 3	Year 4	Year 5
13		CCA rate (rt)		0.25	0.25	0.25	0.25	0.25
14		Depreciation (B*rt)		=D15*E13	=E15*F13	=F15*G13	=G15*H13	=H15*I13
15		Book Value	=D8	=D15-E14	=E15-F14	=F15-G14	=G15-H14	=H15-I14
16
17
18		Calculation of after tax net cash flow from the sale of the machine:
19		Proceed from sale of system at the end of year 5	95000
20		Book Value of system at the end of year 5	=I15
21		Gain or Loss on sale	=Proceed From Sale - Book value at the end of sale
22			=D19-D20
23
24		Tax rate	0.36
25		Gain or Loss on sale	=D22
26		Tax on Gain & Loss	=D25*D24
27		Net Proceed from Sale of assets at the end	=Proceed from Sale - Tax Expense on gain or loss
28			=D19-D26
29
30		Hence after-tax net cash flow from the sale of system	=D28
31
32		Loan Payment Calculation:
33		Amount of loan taken	=D7
34		Interest rate	0.09
35		Period	5
36		Annual interest payment	=D33*D34
37		Payment of priciple at the end of year 5	=D33
38
39		Cost of buy option can be calculated as follows:
40
41		Year	0	1	2	3	4	5
42		Interest Payment		=-$D$36	=-$D$36	=-$D$36	=-$D$36	=-$D$36
43		Depreciation		=-E14	=-F14	=-G14	=-H14	=-I14
44		Income Before Tax		=SUM(E42:E43)	=SUM(F42:F43)	=SUM(G42:G43)	=SUM(H42:H43)	=SUM(I42:I43)
45		Tax expense		=-E44*$D$24	=-F44*$D$24	=-G44*$D$24	=-H44*$D$24	=-I44*$D$24
46		Net Income		=E44+E45	=F44+F45	=G44+G45	=H44+H45	=I44+I45
47		Add Depreciation		=-E43	=-F43	=-G43	=-H43	=-I43
48		Cost of asset	=-D7
49		Loan Value	=D33
50		Net cash flow from the sale of the machine						=D30
51		Debt principle repayment						=-D33
52		Net Cash Flow from Buying the Machine	=SUM(D46:D51)	=SUM(E46:E51)	=SUM(F46:F51)	=SUM(G46:G51)	=SUM(H46:H51)	=SUM(I46:I51)
53		Cost of capital (i) = cost of debt	=D34
54		(P/F,i,n)	=1/((1+$D53)^D41)	=1/((1+$D53)^E41)	=1/((1+$D53)^F41)	=1/((1+$D53)^G41)	=1/((1+$D53)^H41)	=1/((1+$D53)^I41)
55		Present value of net cash flows	=D52*D54	=E52*E54	=F52*F54	=G52*G54	=H52*H54	=I52*I54
56		Cost of purchasing the equipment	=Present Value of net cash flows
57			=SUM(D55:I55)	=SUM(D55:I55)
58
59		Hence net cost of purchasing the equipment is	=-D57
60
61
62		Calculation of Cost of leasing the equipment
63		Annual Lease Payment	35000
64
65
66		Year	0	1	2	3	4
67		Lease Payment	=-D63	=D67	=E67	=F67	=G67
68		Tax Expense	=-D67*$D$24	=-E67*$D$24	=-F67*$D$24	=-G67*$D$24	=-H67*$D$24
69		Net cash flow due to lease	=D67+D68	=E67+E68	=F67+F68	=G67+G68	=H67+H68
70		Cost of capital (i) = cost of debt	=D34
71		(P/F,i,n)	=1/((1+$D70)^D66)	=1/((1+$D70)^E66)	=1/((1+$D70)^F66)	=1/((1+$D70)^G66)	=1/((1+$D70)^H66)
72		Present value of net cash flows	=D69*D71	=E69*E71	=F69*F71	=G69*G71	=H69*H71
73		Cost of leasing the equipment	=Present Value of net cash flows
74			=SUM(D72:H72)	=SUM(D72:H72)
75
76		Hence cost of leasing the equipment is	=-D74
77
78
79		Calculation of Net Advantage of leasing:
80		Net advantage to Leasing	=Cost of Purchasing the equipment - Cost of leasing the equipment
81			=D59-D76	=D59-D76
82
83		Hence net advantage of leasing is	=D81
84
85		Since net advantage of leasing is positive, hence the leasing option should be accepted.
86
87