Question

Lewis Health System Inc. has decided to acquire a new electronic health record system for its Richmond hospital. The system receives clinical data and other patient information from nursing units and other patient care areas, then either displays the information on a screen or stores it for later retrieval by physicians. The system also permits patients to call up their health record on Lewis's website.

The equipment costs $1,000,000, and, if it were purchased, Lewis could obtain a term loan for the full purchase price at a 10 percent interest rate. Although the equipment has a six-year useful life, it is classified as a special-purpose computer, so it falls into the MACRS three-year class. If the system were purchased, a four-year maintenance contract could be obtained at a cost of $20,000 per year, payable at the beginning of each year. The equipment would be sold after four years, and the best estimate of its residual value at that time is $200,000. However, since real-time display system technology is changing rapidly, the actual residual value is uncertain.

As an alternative to the borrow-and-buy plan, the equipment manufacturer informed Lewis that Consolidated Leasing would be willing to write a four-year guideline lease on the equipment, including maintenance, for payments of $260,000 at the beginning of each year. Lewis's marginal federal-plus-state tax rate is 40 percent. You have been asked to analyze the lease-versus-purchase decision, and in the process to answer the following questions:

a. What is the present value cost of owning the equipment?

b. What is the present value cost of leasing the equipment?

c. What is the net advantage to leasing (NAL)?

d. Answer these questions one at a time to see the effect of the change on NAL. That is, starting with the original numbers you used for questions a. and b., what is the NAL if:

- interest rate increases to 12 percent
- the tax rate falls to 34 percent - maintenance cost increases to $25,000 per year
- residual value falls to $150,000
- the system price increases to $1,050,000
e. Do the changes in d. make leasing more or less attractive? Explain.

Answer 1

Soln : a) When owning the equipment

Year	0	1	2	3
EMI cost		315470.8	315470.8	315470.8
Maintenance cost	20000	20000	20000	20000
Cost	20000	335470.8	335470.8	335470.8
Residual value
Depreciation		333300	444500	148100
Tax shield	0	133320	177800	59240
Residual value after income tax
Net cost (cost-tax shield-revenue after tax)	20000	202150.8	157670.8	276230.8
Discount rate	1	1.1	1.21	1.331
PV	20000	183773.5	130306.4	207536.3
NPV	654880.9

b) Cost of leasing the equipment:

Year	0	1	2	3	4
Cost of lease	260000	260000	260000	260000
Discount rate	1	1.1	1.21	1.331	1.4641
PV	260000	236363.6	214876	195341.8
NPV	906581.5

d) When interest rate changed to 12%

Lease
Year	0	1	2	3	4
Cost of lease	260000	260000	260000	260000
Discount rate	1	1.12	1.2544	1.404928	1.573519
PV	260000	232142.8571	207270.4	185062.9
NPV	884476.1

Owning
EMI cost		329234.44	329234.4	329234.4	329234.4
Maintenance cost	20000	20000	20000	20000
Cost	20000	349234.44	349234.4	349234.4	329234.4
Residual value					200000
Depreciation		333300	444500	148100	74100
Tax shield	0	133320	177800	59240	29640
Residual value after income tax					120000
Net cost	20000	215914.44	171434.4	289994.4	179594.4
Discount rate	1	1.12	1.2544	1.404928	1.573519
PV	20000	192780.75	136666.5	206412.3	114135.5
NPV	669995.1

NAL = 214481

When tax rate reduce to 34% and maintenance cost = $25000

Lease
Year	0	1	2	3	4
Cost of lease	260000	260000	260000	260000
Discount rate	1	1.12	1.2544	1.404928	1.573519
PV	260000	232142.8571	207270.4	185062.9
NPV	884476.1

Owning
EMI cost		329234.44	329234.4	329234.4	329234.4
Maintenance cost	25000	25000	25000	25000
Cost	25000	354234.44	354234.4	354234.4	329234.4
Residual value					200000
Depreciation		333300	444500	148100	74100
Tax shield	0	113322	151130	50354	25194
Residual value after income tax					120000
Net cost	25000	240912.44	203104.4	303880.4	184040.4
Discount rate	1	1.12	1.2544	1.404928	1.573519
PV	25000	215100.3929	161913.6	216296.1	116961
NPV	735271.1

NAL = 149205

NAL = 654880.9- 906581.5 = -251700.7