Question

The Button Co. is considering the purchase of a new machine for $30,000 that has a life of 5 years and would be depreciated on straightline basis to a zero salvage value over its life. The machine is expected to save the firm $12,500 per year in operating costs. Alternatively, the firm can lease the machine for $7,300 annually for 5 years, with the first payment due at the end of the first year. The firm's tax rate is 21 percent and its cost of debt is 10 percent. What is the net advantage of leasing (NAL) for the Lessee?

Answer 1

Net advantage of leasing is the NPV of the lease relative to the purchase.

This is calculated by calculating the present value of the advantage each year.

Advantage each year = Cash flow with leasing - cash flow with buying.

Buying :

Cash outflow in year 0 = cost of equipment.

Cash inflow in each year = annual depreciation * tax rate (The depreciation is a tax-deductible expense, and hence provides a depreciation tax shield. This is treated as a cash inflow).

Annual depreciation tax shield = (cost of equipment / depreciable life) * tax rate = ($30,000 / 5) * 21% = $1,260.

Leasing :

Net cash outflow with leasing = lease payment * (1 - tax rate) = $7,300 * (1 - 21%) = $5,767

NPV of leasing vs buying

Advantage each year = Cash flow with leasing - cash flow with buying.

Present value factor (discount factor) each year = 1 / (1 + discount rate)year.

Discount rate = after-tax cost of borrowing = interest rate on borrowing * (1 - tax rate) = 10% * (1 - 21%) = 7.9%.

Net Advantage of leasing each year = advantage amount * discount factor.

NPV of the lease relative to the purchase = $1,869.12

NPV of the lease relative to the purchase = $1,869.12