Question

You work as financial analyst at Herman Miller Furniture company. You are evaluating g a potential lease agreement on a new machine. The new machine can be purchased on January 1 for $10,000 and can be depreciated over 5-year period using straight line method. The machine has an 8-year actual life and the salvage value at the end of the 8 years is $0. The operating expenses of the machine will be $500 per year. The lease calls for 8 annual payments of $2,000 per year with the first payment occurring immediately. (assume the lease payments will occur at the beginning of each year and the tax benefits associated with the lease payment occurs at the end of the year) the interest rate on the company’s debt is 10%. The weighted average cost of capital of the firm is 15%. The corporate tax rate is 30%.

What is the cost of owning?

What is the cost of leasing?

What is Net Advantage to Leasing/

What is the minimum salvage value for you to be indifferent between lease and buying?

Answer 1

Assumption for answer ,

1. new machine will be purchased all by debt fund

2. principle of debt paid at end of 8th year , only interest have been paid during years

Cost of owning the machine is calculated in Present value term with discounting factor of weighted average cost of capital (15%)

8-year Depreciation Schedule
Year	1	2	3	4	5	6	7	8
Depr. Rate	12.5%	12.5%	12.5%	12.5%	12.5%	12.5%	12.5%	12.5%
Lessee's Depr. Exp.	$1,250	$1,250	$1,250	$1,250	$1,250	$1,250	$1,250	$1,250
EOY Book Value	$8,750	$7,500	$6,250	$5,000	$3,750	$2,500	$1,250	$0
Lessor's Depr. Exp.	$1,250	$1,250	$1,250	$1,250	$1,250	$1,250	$1,250	$1,250
EOY Book Value	$8,750	$7,500	$6,250	$5,000	$3,750	$2,500	$1,250	$0

Year =	0	1	2	3	4	5	6	7	8
Cost of Owning
Equipment cost	($10,000)
Loan amount	$10,000
Interest on loan		($1,000)	($1,000)	($1,000)	($1,000)	($1,000)	($1,000)	($1,000)	($1,000)
Tax savings on int.		$300	$300	$300	$300	$300	$300	$300	$300
Repayment of loan									($10,000)
Maintenance Cost	($500)	($500)	($500)	($500)	($500)	($500)	($500)	($500)	($500)
Tax savings on main.	$150	$150	$150	$150	$150	$150	$150	$150	$150
Tax savings on depr.		$375	$375	$375	$375	$375	$375	$375	$375
Residual value						$0	$0	$0	$0
Tax on res. value
Net cash flow	($350)	($675)	($675)	($675)	($675)	($675)	($675)	($675)	($10,675)
PV owning	($395.00)
Cost of Leasing
Lease payment	($2,000)	($2,000)	($2,000)	($2,000)	($2,000)	($2,000)	($2,000)	($2,000)	($2,000)
Tax savings on lease	$600	$600	$600	$600	$600	$600	$600	$600	$600
Net cash flow	($1,400)	($1,400)	($1,400)	($1,400)	($1,400)	($1,400)	($1,400)	($1,400)	($1,400)
PV leasing	($1,493.33)

Net Advantage to Leasing = NAL = PV Owning cost   -   PV Leasing cost      =

($1,098.33)

TO in different the lease and buying the salvage value should be greater than 3358