Question

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?

Answer 1

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.