Question

PROBLEM 2 West Hills Village (WHV) in Rapid City, South Dakota is evaluating a guideline lease agreement on laundry equipment that costs $250,000 and falls into the MACRS three-year class. The home can borrow at an 8 percent rate on a four-year loan if WHV decided to borrow and buy rather than lease. The laundry equipment has a four-year economic life, and its estimated residual value is $50,000 at the end of Year 4. If WHV buys the equipment, it would purchase a maintenance contract which costs $5,000 per year, payable at the beginning of each year. The lease terms, which include maintenance, call for a $71,000 lease payment at the beginning of each year. WNV's tax rate is 40 percent. Should the home lease or buy?

Answer 1

a]	LEASING:
	Discount rate = 8%*(1-40%) =	4.80%
	Annual after tax lease rent = 71000*(1-40%) =	$            42,600
	NPV of leasing = -42600*(1.048^4-1)*1.048/(0.048*1.048^4) =	$        -159,046
	[Formula for PV of annuity due is used]
b]	PURCHASE:
	Loan amortization:
	Loan installments = 250000*0.08*1.08^4/(1.08^4-1) =	$            75,480
	Loan amortization schedule:	0	1	2	3	4
	Beinning balance of loan		$         250,000	$     194,520	$   134,602	$            69,890
	Interest at 8%		$           20,000	$       15,562	$      10,768	$              5,590
	Total		$         270,000	$     210,082	$   145,370	$            75,480
	Less: Installment		$           75,480	$       75,480	$      75,480	$            75,480
	Ending balance of loan		$         194,520	$     134,602	$      69,890	$                     -
	Cash flows for purchasing:
	Principal repayment [Installment-Interest]		$          -55,480	$     -59,918	$    -64,712	$          -69,890	$    -250,000
	After tax interest [Interest*(1-40%)]		$          -12,000	$        -9,337	$      -6,461	$             -3,354
	Depreciation		$           82,500	$     112,500	$      37,500	$            17,500	$     250,000
	Tax shield on depreciation at 40%		$           33,000	$       45,000	$      15,000	$              7,000	$     100,000
	After tax maintenance cost [5000*60%]	$            (3,000)	$           (3,000)	$       (3,000)	$      (3,000)
	Loan receipt	$          250,000
	Purchase of asset	$        -250,000
	After tax salvage value [50000*(1-40%)]					$            30,000
	After tax cash flows of purchase	$             -3,000	$          -37,480	$     -27,255	$    -59,173	$          -36,244
	PVIF at 4.8%	1	0.95420	0.91049	0.86879	0.82900
	PV at 4.8%	$             -3,000	$          -35,763	$     -24,816	$    -51,409	$          -30,046
	NPV of purchasing	$        -145,034
c]	Net advantage of leasing = -159046-(-145034) =	$          -14,012
	As the NAL of leasing is negative, buying is
	recommended.