Question

Lewis Health System Inc. has decided to acquire a new electronic health record system for its Richmond hospital. The system receives clinical data and other patient information from nursing units and other patient care areas, then either displays the information on a screen or stores it for later retrieval by physicians. The system also permits patients to call up their health record on Lewis's website. The equipment costs $1,000,000, and, if it were purchased, Lewis could obtain a term loan for the full purchase price at a 10 percent interest rate. Although the equipment has a six-year useful life, it is classified as a special-purpose computer, so it falls into the MACRS three-year class. If the system were purchased, a four-year maintenance contract could be obtained at a cost of $20,000 per year, payable at the beginning of each year. The equipment would be sold after four years, and the best estimate of its residual value at that time is $200,000. However, since real-time display system technology is changing rapidly, the actual residual value is uncertain. As an alternative to the borrow-and-buy plan, the equipment manufacturer informed Lewis that Consolidated Leasing would be willing to write a four-year guideline lease on the equipment, including maintenance, for payments of $260,000 at the beginning of each year. Lewis's marginal federal-plus-state tax rate is 40 percent. You have been asked to analyze the lease-versus-purchase decision, and in the process to answer the following questions: a. What is the present value cost of owning the equipment? b. What is the present value cost of leasing the equipment? c. What is the net advantage to leasing (NAL)? d. Answer these questions one at a time to see the effect of the change on NAL. That is, starting with the original numbers you used for questions a. and b., what is the NAL if: - interest rate increases to 12 percent - the tax rate falls to 34 percent - maintenance cost increases to $25,000 per year - residual value falls to $150,000 - the system price increases to $1,050,000 e. Do the changes in d. make leasing more or less attractive? Explain.

Answer 1

a. Present value cost of owning the equipment			MACRS rates	Depn. Amt.	Tax savings	PV F at 10%	PV at 10%
Initial cost	-1000000		33.33	333300	133320	0.90909	121200
PV of Beg.of yr. After-tax Maintenance costs(20000*(1-40%)*(1-1.10^-4)/0.1)*(1.1)	-41842		44.45	444500	177800	0.82645	146942
PV of Depn. Tax shields(As per Table)	332895		14.81	148100	59240	0.75131	44508
PV of after-tax salvage(200000*1-40%)/1.1^4	81962		7.41	74100	29640	0.68301	20245
PV cost of owning the equipment	-626986		100	1000000	400000		332895
b.Present value cost of leasing the equipment
After-tax cost(PV) of leasing=
260000*(1-40%)*(1-1.1^-4)/0.1*(1.1)
543949
c. Net advantage to leasing (NAL)
PV cost of owning	626986
PV cost of Leasing	543949
NAL	83037
d..
1….Interest rate increases to 12 percent
a. Present value cost of owning the equipment			MACRS rates	Depn. Amt.	Tax savings	PV F at 12%	PV at 12%
Initial cost	-1000000		33.33	333300	133320	0.89286	119036
PV of Beg.of yr. After-tax Maintenance costs(20000*(1-40%)*(1-1.12^-4)/0.12)*(1.12)	-40822		44.45	444500	177800	0.79719	141741
PV of Depn. Tax shields(As per Table)	321779		14.81	148100	59240	0.71178	42166
PV of after-tax salvage(200000*1-40%)/1.12^4	76262		7.41	74100	29640	0.63552	18837
PV cost of owning the equipment	-642780		100	1000000	400000		321779
b.Present value cost of leasing the equipment
After-tax cost(PV) of leasing=
260000*(1-40%)*(1-1.12^-4)/0.12*(1.12)
530686
c. Net advantage to leasing (NAL)
PV cost of owning	642780
PV cost of Leasing	530686
NAL	112095
2...the tax rate falls to 34 percent
a. Present value cost of owning the equipment			MACRS rates	Depn. Amt.	Tax savings at 34%	PV F at 10%	PV at 10%
Initial cost	-1000000		33.33	333300	113322	0.90909	103020
PV of Beg.of yr. After-tax Maintenance costs(20000*(1-34%)*(1-1.10^-4)/0.1)*(1.1)	-46026		44.45	444500	151130	0.82645	124901
PV of Depn. Tax shields(As per Table)	282960		14.81	148100	50354	0.75131	37832
PV of after-tax salvage(200000*1-34%)/1.1^4	90158		7.41	74100	25194	0.68301	17208
PV cost of owning the equipment	-672908		100	1000000	340000		282960
b.Present value cost of leasing the equipment
After-tax cost(PV) of leasing=
260000*(1-34%)*(1-1.1^-4)/0.1*(1.1)
598344
c. Net advantage to leasing (NAL)
PV cost of owning	672908
PV cost of Leasing	598344
NAL	74564
3...maintenance cost increases to $25,000 per year
a. Present value cost of owning the equipment			MACRS rates	Depn. Amt.	Tax savings	PV F at 10%	PV at 10%
Initial cost	-1000000		33.33	333300	133320	0.90909	121200
PV of Beg.of yr. After-tax Maintenance costs(25000*(1-40%)*(1-1.10^-4)/0.1)*(1.1)	-52303		44.45	444500	177800	0.82645	146942
PV of Depn. Tax shields(As per Table)	332895		14.81	148100	59240	0.75131	44508
PV of after-tax salvage(200000*1-40%)/1.1^4	81962		7.41	74100	29640	0.68301	20245
PV cost of owning the equipment	-637447		100	1000000	400000		332895
b.Present value cost of leasing the equipment
After-tax cost(PV) of leasing=
260000*(1-40%)*(1-1.1^-4)/0.1*(1.1)
543949
c. Net advantage to leasing (NAL)
PV cost of owning	637447
PV cost of Leasing	543949
NAL	93498
4..residual value falls to $150,000
a. Present value cost of owning the equipment			MACRS rates	Depn. Amt.	Tax savings	PV F at 10%	PV at 10%
Initial cost	-1000000		33.33	333300	133320	0.90909	121200
PV of Beg.of yr. After-tax Maintenance costs(25000*(1-40%)*(1-1.10^-4)/0.1)*(1.1)	-52303		44.45	444500	177800	0.82645	146942
PV of Depn. Tax shields(As per Table)	332895		14.81	148100	59240	0.75131	44508
PV of after-tax salvage(150000*1-40%)/1.1^4	61471		7.41	74100	29640	0.68301	20245
PV cost of owning the equipment	-657937		100	1000000	400000		332895
b.Present value cost of leasing the equipment
After-tax cost(PV) of leasing=
260000*(1-40%)*(1-1.1^-4)/0.1*(1.1)
543949
c. Net advantage to leasing (NAL)
PV cost of owning	657937
PV cost of Leasing	543949
NAL	113988
5..the system price increases to $1,050,000
a. Present value cost of owning the equipment			MACRS rates	Depn. Amt.	Tax savings	PV F at 10%	PV at 10%
Initial cost	-1050000		33.33	349965	139986	0.90909	127260
PV of Beg.of yr. After-tax Maintenance costs(20000*(1-40%)*(1-1.10^-4)/0.1)*(1.1)	-41842		44.45	466725	186690	0.82645	154289
PV of Depn. Tax shields(As per Table)	349539		14.81	155505	62202	0.75131	46733
PV of after-tax salvage(200000*1-40%)/1.1^4	81962		7.41	77805	31122	0.68301	21257
PV cost of owning the equipment	-660341		100	1050000	420000		349539
b.Present value cost of leasing the equipment
After-tax cost(PV) of leasing=
260000*(1-40%)*(1-1.1^-4)/0.1*(1.1)
543949
c. Net advantage to leasing (NAL)
PV cost of owning	660341
PV cost of Leasing	543949
NAL	116392
As seen from all variations in d.(1 to 5), LEASING less COSTLIER than owning