Question
In: Accounting
Northwest Lumber Company needs to expand its facilities. To do so, the firm must acquire a...
Northwest Lumber Company needs to expand its facilities. To do so, the firm must acquire a machine costing $80,000. The machine can be leased or purchased. The firm is in the 21% tax bracket, and its after-tax cost of debt is 9%. The terms of the lease and purchase plans are as follows:
Lease: The leasing arrangement requires beginning-of-year payments of $19,800 over 5 years. All maintenance costs will be paid by the lessor. The lessee will exercise its option to purchase the asset for $24,000 at termination of the lease. Ignore any future tax benefit associated with the purchase of the equipment at the end of year 5 under the lease option.
Purchase: If the firm purchases the machine, its cost of $80,000 will be financed with a 14% loan amortised over 5-year period. The machine will be depreciated under MACRS using a 5-year recovery period. The firm will pay $2,000 per year at the beginning of the year for a service contract that covers all maintenance costs. The firm plans to keep the equipment and use it beyond its 5-year recovery period.
- Determine the after-tax cash outflows of Northwest Lumber under each alternative.
- Find the present value of each after-tax cash outflow stream, using the after-tax cost of debt.
- Which alternative-lease or purchase-would you recommend?
Solutions
Expert Solution
a.
| Year | Lease payments | Tax shield @21% | Net after tax Cash outflow |
| 0 | $ 19,800 | $ - | $ 19,800 |
| 1 | $ 19,800 | $ 4,158 | $ 15,642 |
| 2 | $ 19,800 | $ 4,158 | $ 15,642 |
| 3 | $ 19,800 | $ 4,158 | $ 15,642 |
| 4 | $ 19,800 | $ 4,158 | $ 15,642 |
| 5 | $ 24,000 | $ - | $ 24,000 |
| Year | Interest | Principal repayment | Depreciation | Maintenance cost | Total cost | Tax shield @21%(interest + depreciation + maintenance) | Net after tax Cash outflow |
| 0 | $ - | $ - | $ - | $ 2,000 | $ 2,000 | $ - | $ 2,000 |
| 1 | $ 11,200 | $ 16,000 | $ 16,000 | $ 2,000 | $ 29,200 | $ 6,132 | $ 23,068 |
| 2 | $ 8,960 | $ 16,000 | $ 25,600 | $ 2,000 | $ 36,560 | $ 7,678 | $ 19,282 |
| 3 | $ 6,720 | $ 16,000 | $ 15,360 | $ 2,000 | $ 24,080 | $ 5,057 | $ 19,663 |
| 4 | $ 4,480 | $ 16,000 | $ 9,216 | $ 2,000 | $ 15,696 | $ 3,296 | $ 19,184 |
| 5 | $ 2,240 | $ 16,000 | $ 9,216 | $ - | $ 11,456 | $ 2,406 | $ 15,834 |
Working;
Loan repayment schedule
| Year | Repayment ($80,000/5 + interest every year) | Interest | Principal repayment | Balance |
| 0 | $ - | $ - | $ - | $ 80,000 |
| 1 | $ 27,200 | $ 11,200 | $ 16,000 | $ 64,000 |
| 2 | $ 24,960 | $ 8,960 | $ 16,000 | $ 48,000 |
| 3 | $ 22,720 | $ 6,720 | $ 16,000 | $ 32,000 |
| 4 | $ 20,480 | $ 4,480 | $ 16,000 | $ 16,000 |
| 5 | $ 18,240 | $ 2,240 | $ 16,000 | $ - |
Depreciation working;
| Year | Depreciation rate as per MACRS for 5 years | Depreciation |
| 1 | 20.00% | 16000 |
| 2 | 32.00% | 25600 |
| 3 | 19.20% | 15360 |
| 4 | 11.52% | 9216 |
| 5 | 11.52% | 9216 |
b.
| Year | Lease payments | Tax shield @21% | Net after tax Cash outflow | PVF @ 9% | Present value |
| 0 | $ 19,800 | $ - | $ 19,800 | 1 | $ 19,800 |
| 1 | $ 19,800 | $ 4,158 | $ 15,642 | 0.9174 | $ 14,350 |
| 2 | $ 19,800 | $ 4,158 | $ 15,642 | 0.8417 | $ 13,166 |
| 3 | $ 19,800 | $ 4,158 | $ 15,642 | 0.7722 | $ 12,079 |
| 4 | $ 19,800 | $ 4,158 | $ 15,642 | 0.7084 | $ 11,081 |
| 5 | $ 24,000 | $ - | $ 24,000 | 0.6499 | $ 15,598 |
| Total | $ 86,073 |
| Year | Interest | Principal repayment | Depreciation | Maintenance cost | Total cost | Tax shield @21% | Net after tax Cash outflow | PVF @ 9% | Present value |
| 0 | $ - | $ - | $ - | $ 2,000 | $ 2,000 | $ - | $ 2,000 | 1 | $ 2,000 |
| 1 | $ 11,200 | $ 16,000 | $ 16,000 | $ 2,000 | $ 29,200 | $ 6,132 | $ 23,068 | 0.9174 | $ 21,163 |
| 2 | $ 8,960 | $ 16,000 | $ 25,600 | $ 2,000 | $ 36,560 | $ 7,678 | $ 19,282 | 0.8417 | $ 16,230 |
| 3 | $ 6,720 | $ 16,000 | $ 15,360 | $ 2,000 | $ 24,080 | $ 5,057 | $ 19,663 | 0.7722 | $ 15,184 |
| 4 | $ 4,480 | $ 16,000 | $ 9,216 | $ 2,000 | $ 15,696 | $ 3,296 | $ 19,184 | 0.7084 | $ 13,590 |
| 5 | $ 2,240 | $ 16,000 | $ 9,216 | $ - | $ 11,456 | $ 2,406 | $ 15,834 | 0.6499 | $ 10,291 |
| Total |
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