Question

Spectrum Corporation is considering leasing a new equipment. The lease lasts for 8 years. The lease calls for 8 payments of $142,000 per year with the first payment occurring immediately. The equipment would cost $1,020,000 to buy and would be straight-line depreciated to a zero salvage value over 8 years. The actual salvage value is negligible because of technological obsolescence. The firm can borrow at a rate of 6%. The corporate tax rate is 25%. The corporate tax rate is 25%. What is the NPV of the lease relative to the purchase?

$75,683.48

$84,201.67

-$59,573.24

-$67,328.20

$61,443.79

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 = ($1,020,000 / 8) * 25% = $9,750.

Leasing :

Net cash outflow with leasing = lease payment * (1 - tax rate) = $142,000 * (1 - 25%) = $106,500.

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) = 6% * (1 - 25%) = 4.5%.

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

NPV of the lease relative to the purchase = $75,683.48