Question

Lark corporation is considering the acquisition of an asset for use in its business over the next five years. However, Lark must decide whether ti would be better served by leasing the asset or buying it. An appropriate asset could be purchased for $15,000.00 and it would qualify as a three-year asset under MACRS classification. Assume that the election to expense assets under section 179 is made, but any available additional first-year depreciation is not claimed, and that the asset is not expected to to have a salvage value at the end of its use by Lark. Alternatively, Lark coule lease the asset for a $3,625.00 annual cost over the 5-year period. If Lark is in the 34% tax bracket, would you recommend that Lark buy or lease the asset? In your calculations, assume that 10% is an appropriate discount factor.

Answer 1

If Lark purchases the asset, it can take advantage of section 179 which allows full depreciation in the first year.

If Lark leases the asset, it can be considered as True Lease or Tax lease which will allow expensing the lease rentals in income statement as per IRS regulations.

Hence, to determine which option is better, we need to calculate the present value of the overall cost after taking into account depreciation and tax benefits.

If Lark purchases the asset, it can take advantage of section 179 and charge entire amount as depreciation expense in the first year. The tax advantage at the end of the year =15000 * 34% = 5,100

Present value of tax benefit = 5100 / (1+Discount rate) = 5100 / (1+10%) = $4636.36

Net Present Cost of the asset = 15,000 - 4,636.36 = $10,363.64

B) Option of Leasing

If Larks leases the asset, it has to be $3625 per annum over five years. It can claim this lease rental as operating expense.

The net expense every year = Lease Rental - Tax Shield

Net after-tax lease expense every year = 3625 * (1-Tax%) = 3625 * (1-34%) = 2392.50

Preset value of cost of lease expenses = 2392.5 / (1+10%) + 2392.5 / (1+10%)^2 +...2392.5/(1+10%)^5

PV (Net Lease expense) = 2392.5 * ((1+10%)^5 - 1) / (10% * (1+10%)^5 = $ 9069.46

Since the PV of lease cost is only at $9,069.46 as compared to PV cost of purchasing the asset at $10,363.64,

It is better for Lark to lease the asset.