Question

Suppose Proctor​ & Gamble​ (P&G) is considering purchasing $17million in new manufacturing equipment. If it purchases the​ equipment, it will depreciate it for tax purposes on a​ straight-line basis over five​ years, after which the equipment will be worthless. It will also be responsible for maintenance expenses of $1.00 million per​ year, paid in each of years 1 through 5. It can also lease the equipment under a true tax lease for $ 4.2 million per year for the five​ years, in which case the lessor will provide necessary maintenance. Assume​ P&G's tax rate is 35%​,its borrowing cost is 6.0%​,and that the tax deductibility benefit of the lease payments occurs at the same time as when the lease payment is made.​ (Note: the help file for this question does not make this timing​ assumption)

a. What is the NPV associated with leasing the equipment versus borrowing and buying​ it?

b. What is the​ break-even lease rate-- that ​is, what lease amount could​ P&G pay each year and be indifferent between leasing and buying through​ borrowing?

Answer 1

a) cal culation NPV by borrowing and buying

Year	Revenue	Maintenance	dep	EBT (Rev – Main- Dep)	EAT {EBT-*(1-tax rate)}	dep	cash flow	PV value at 6% cost of capital	PV of cash flow
0							-17		-17
1	0	1	3.4	-4.4	-2.86	3.4	0.54	1.06	0.50
2	0	1	3.4	-4.4	-2.86	3.4	0.54	1.12	0.48
3	0	1	3.4	-4.4	-2.86	3.4	0.54	1.19	0.45
4	0	1	3.4	-4.4	-2.86	3.4	0.54	1.26	0.42
5	0	1	3.4	-4.4	-2.86	3.4	0.54	1.33	0.40

Net present value of cash flow = -14.725 $

Dep cal = (17-0)/5 = 3.4

Calculating NPV by leasing

Year	Revenue	lease rent	EAT( cash flow)
0
1	0	-4.2	-2.73
2	0	-4.2	-2.73
3	0	-4.2	-2.73
4	0	-4.2	-2.73
5	0	-4.2	-2.73

Net present value of cash flow - 13.65

since there is no funding therefore there is no cost of capital associated. so no Present value calculation required.

so ultimately leasing will profitable way than borrowing because net cash out flow is low

B) Break Even Lease Rate

(14.725 - 13.65) / 5 = -0.22 there must be EAT-.22 more cash flow each year

that is possible by -0.22/(1-.35) = .33 increase in lease rent each year

Year	Revenue	lease rent	EAT( cash flow)
0
1	0	-4.53	-2.94
2	0	-4.53	-2.94
3	0	-4.53	-2.94
4	0	-4.53	-2.94
5	0	-4.53	-2.94

net cash flow = -14.72