Question

Suppose Clorox can lease a new computer data processing system for $971,000 per year for five years.? Alternatively, it can purchase the system for $4.22 million. Assume Clorox has a borrowing cost of 6.7 % and a tax rate of 35%?, and the system will be obsolete at the end of five years.

a. If Clorox will depreciate the computer equipment on a? straight-line basis over the next five? years, and if the lease qualifies as a true tax? lease, is it better to lease or finance the purchase of the? equipment?

b. Suppose that if Clorox buys the? equipment, it will use accelerated depreciation for tax purposes.? Specifically, suppose it can expense 20% of the purchase price immediately and can take depreciation deductions equal to 32%?, 19.2%?, 11.52%?, 11.52%, and 5.76% of the purchase price over the next five years. Compare leasing with purchase in this case.

Answer 1

a) If clorox uses SLM method of depreciation

1) Buy option

Installment = Cost/PVIFA(6.7%,5)

=4220000/4.1333

=1020965$

Repayment schedule

			Towards
Year	Opening balance	Installment	Interest @ 6.7%	Principal	Closing balance
1	4220000	1020965	282740	738225	3481775
2	3481775	1020965	233279	787686	2694089
3	2694089	1020965	180504	840461	1853628
4	1853628	1020965	124193	896772	956856
5	956856	1020965	64109	956856	0

Depreciation = 4220000/5 =844000$

Statement showing NPV

Particulars	0	1	2	3	4	5	Total
Interest expense		282740	233279	180504	124193	64109
Depreciation		844000	844000	844000	844000	844000
Total		1126740	1077279	1024504	968193	908109
Tax savings @ 35%		394359	377047.7	358576.4	338867.6	317838.2
PAT		732381	700231.4	665927.6	629325.5	590270.9
Less depreciation		844000	844000	844000	844000	844000
Cash out flow after tax		-111619	-143769	-178072	-214675	-253729
Payment of principal		738225	787686	840461	896772	956856
Total cash outflow		626606	643917	662389	682097	703127
PVIF @ 4.355%		0.958267	0.918277	0.879954	0.843232	0.808042
Present value		600456.1	591294.2	582871.9	575166.2	568155.4	2917944

Option 2) To lease

Statement showing NPV

Particulars	0	1	2	3	4	5	Total
Lease expense		971000	971000	971000	971000	971000
Tax @ 35%		339850	339850	339850	339850	339850
After tax cash out flow		631150	631150	631150	631150	631150
PVIF @ 4.355%		0.958267	0.918277	0.879954	0.843232	0.808042
Present value		604810.5	579570.2	555383.3	532205.7	509995.4	2781965

Thus it is better to lease than to buy

B) If clorox uses accelerated depreciation method

Statement showing depreciation

Year	Opening balance	Depreciation rates	Depreciayion = 4220000* depreciation rates	Closing balance
0	4220000	20%	844000	3376000
1	3376000	32%	1350400	2025600
2	2025600	19.20%	810240	1215360
3	1215360	11.52%	486144	729216
4	729216	11.52%	486144	243072
5	243072	5.76%	243072	0

Statement showing NPV

Particulars	0	1	2	3	4	5	Total
Interest expense		282740	233279	180504	124193	64109
Depreciation	844000	1350400	810240	486144	486144	243072
Total	844000	1633140	1043519	666648	610337	307181
Tax savings @ 35%	295400	571599	365231.7	233326.8	213618	107513.4
PAT	548600	1061541	678287.4	433321.2	396719.1	199667.7
Less depreciation	844000	1350400	810240	486144	486144	243072
Cash out flow after tax	-295400	-288859	-131953	-52822.8	-89425	-43404.4
Payment of principal		738225	787686	840461	896772	956856
Total cash outflow	-295400	449366	655733	787638	807347	913451
PVIF @ 4.355%	1	0.958267	0.918277	0.879954	0.843232	0.808042
Present value	-295400	430612.8	602144.6	693085.8	680780.6	738106.6	2849330

Still it is better to lease the equipment