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Sirius has decided to acquire a new equipment at a cost of $748,000. The equipment has...

Sirius has decided to acquire a new equipment at a cost of $748,000. The equipment has an expected life of 6 years and will be depreciated using 5-year MACRS with rates of .20, .32, .192, .1152, .1152, and .0576 (note that 5-year MACRS depreciation actually takes place over 6 years). There is no actual salvage value. Travis Capital has offered to lease the equipment to Sirius for $153,000 a year for 6 years, with lease payment at the end of each year. Sirius has a cost of equity of 11 percent, a pre-tax cost of debt of 7 percent, and a marginal tax rate of 25 percent. Should Sirius lease or buy?

Solutions

Expert Solution

LEASE OR BUY DECISION

We will analyse situation based on present value of mentioned cashoutflows under each option.

Lets evaluate each option seperately: -

LEASE OPTION: -

Cost of capital = 11%

Annual Lease payment = 1,43,000

Tax rate = 25%

No depreciation can be claimed under lease,

Lets Calculate present value of annual cashoutflows: -

Year Actual Cashflow Tax benefits Net Cashflow Discounted
1 1,53,000 38,250 1,14,750 1,03,378
2 1,53,000 38,250 1,14,750 93,134
3 1,53,000 38,250 1,14,750 83,904
4 1,53,000 38,250 1,14,750 75,589
5 1,53,000 38,250 1,14,750 68,099
6 1,53,000 38,250 1,14,750 61,350
TOTAL CASH OUTFLOWS 4,85,454

BUY OPTION
599

Assumption: - As mentioned in question, cost of debt is 7%, we are assuming that, company will buy equipement by incurring debt at 7% interest rate. Also, repayment terms are not mentioned in question and therefore we are assuming that principal will be repaid equally along with applicable interest for that year. Accordingly, following is loan amortoization table for loan repayment: -

Year Opening Balance Principal Interest Repaid Closing balance Cash Outflow
1 0 7,48,000 52,360 1,24,667 6,23,333 1,77,027
2 6,23,333 0 43,633 1,24,667 4,98,667 1,68,300
3 4,98,667 0 34,907 1,24,667 3,74,000 1,59,573
4 3,74,000 0 26,180 1,24,667 2,49,333 1,50,847
5 2,49,333 0 17,453 1,24,667 1,24,667 1,42,120
6 1,24,667 0 8,727 1,24,667 0 1,33,393

Now lets calculate present value of cash outflows: -

1 2 3 4 5 6 7 8
(2+3) 25% of 4 7- (5 + 6)
Year Interest Depreciation Total Taxable expenses Tax Benefit Loan Repayment Net Cash outflows Discounted CF
1 52,360 1,49,600 2,01,960 50,490 1,77,027 1,26,537 1,13,997
2 43,633 2,39,360 2,82,993 70,748 1,68,300 97,552 79,175
3 34,907 1,43,616 1,78,523 44,631 1,59,573 1,14,943 84,045
4 26,180 86,170 1,12,350 28,087 1,50,847 1,22,759 74,278
5 17,453 86,170 1,03,623 25,906 1,42,120 1,16,214 68,967
6 8,727 43,085 51,811 12,953 1,33,393 1,20,440 64,392
DISCOUNTE CASHFLOWS 4,84,855

Cashflows are discounted as cashflow / (1 + r)t  . Example 97,552 for year 2 is calculated as 97552 / (1 +0.11)2 i.e. 79,175.

CONCLUSION: -Since value of discounted cashflows are lower in case of buy model by $599 ($4,85,454 - $4,84,855). Company should go for buying machinary as it involves lower cash outflows.

ekkarill92 answered 2 years ago
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