Question

Problem 1

Brooklyn Family Medicine, a for-profit group practice, has decided to acquire a new top-of-the-line electrocardiogram (ECG) machine. One alternative would be to purchase the equipment outright for $60,400. If purchased, the practice could borrow the amount needed from a local bank at a 6 percent interest rate. Also, if purchased, the practice would have to sign a maintenance contract with a vendor that would cost $1,600 annually, payable at the beginning of each year.  Alternatively, the practice could lease the machine on a four-year guideline lease with a payment of $15,600 payable at the beginning of each year. The lease includes maintenance. The ECG machine falls into the MACRS three-year class (allowances are 33, 45, 15, and 7 percent in Years 1 through 4, respectively), the machine’s estimated residual value is $14,000, and the practice’s federal-plus-state tax rate is 34 percent. In addition, the CEO of Brooklyn Family Medicine believes that the recent election of a new state governor could result in an increase of the practice’s tax rate from 34 percent to 40 percent, but she doesn’t know how this will affect the analysis.

Part a

Should the practice buy or lease the equipment? Please explain and document your answer. Assume a tax rate of 34 percent.  

Part b

What if the tax rate increases from 34% to 40%? Please explain and document your answer.

Answer 1

Ideally for a question like this, we need to be given the Discounting Rate at which we discount the payments made or received for a period other than current period (because discounting factor at time 0 is 1)

Here in this question we haven't been provided the discounting rate which means that the time value of money has been ignored by the question (which is not correct). Therefore for making the capital budgeting problem more meaningful we assume the discounting factor to be 10% and solve the problem accordingly. You can assume any other rate if you want.

(a) Alternative 1: Loan taken

Interest expense at 6% per annum = 60400*6/100 = 3624

Tax benefit on interest expense = 3624*34% = 1232

Net outflow per annum on account of interest = 3624-1232 = 2392

Annual maintenance contract outfloe = 1600 (beginning of each year for 4 years)

Depreciation expense each year = 60400*33% + 60400*45% + 60400*15% + 60400*7% = 19932 (yr 1) + 27180 (yr 2) + 9060 (yr 3) + 4228 (yr 4)

Salvage value at the end = 14000

repayment of loan at the end = 60400

Let us calculate the present value of all outflows and inflows in the form of tax benefits :

PARTICULARS	YEAR 1	YEAR 2	YEAR 3	YEAR 4	YEAR 0
INTEREST - TAX BENEFIT	- 2392	- 2392	- 2392	- 2392
REPAYMENT OF LOAN				- 60400
SALVAGE - TAX				+ 9240
TAX BENEFIT ON DEPRECIATION	+ 6777	+ 9241	+ 3080	+ 1438
ANNUAL MAINTENANCE - TAX BENEFIT	-1056	- 1056	-1056	+ 544	-1600

without considering discounting factor, we have total outflow of 44,416 from this alternative

whereas if we use discounting factor of 10%, outflow = 29,285.52

Alternative 2: Lease is taken:

we have to incur only the lease payment cost and will get tax benefit on it as an inflow

	year 1	year 2	year 3	year 4	year 0
lease payment	-15600	-15600	-15600		-15600
tax benefit at 34%	5304	5304	5304	5304	-

Here if we see total outflow without discounting factor, we get total outflow = 41,184

Taking 10% as our discounting factor, we get total outflow = 37,582

Thus outflow in without lease option is higher if we do not consider time value of money - which makes buying a better option. Considering time value of money in our calculations show leasing the equipment as a better choice.

(b) If the tax rate increased from 34% to 40% the tax benefit obtained from depreciation, interest payments would be higher. Also the amount received after deducting tax from salvage value of 14000 would be lower. In the leasing option, higher benefit would be received from lease payments made.

PARTICULARS	YEAR 1	YEAR 2	YEAR 3	YEAR 4	YEAR 0
INTEREST - TAX BENEFIT	- 2174	- 2174	- 2174	- 2174
REPAYMENT OF LOAN				- 60400
SALVAGE - TAX				+ 8400
TAX BENEFIT ON DEPRECIATION	+ 7973	+ 10872	+ 3624	+ 1691
ANNUAL MAINTENANCE - TAX BENEFIT	-960	- 960	-960	+ 640	-1600

Net outflow without time value of money for Alternative 1 i.e. buying is 40,376

With DF = 10% , Net outflow = 25,847

Similarly for alternative 2, i.e. leases,

we see that outflow without time value of money = 37440

outflow with discounting factor at 10%, outflow = 34614

	year 1	year 2	year 3	year 4	year 0
lease payment	-15600	-15600	-15600		-15600
tax benefit at 34%	6240	6240	6240	6240	-