Question

Please show workings clearly on excel sheet

Your company is considering either purchasing or leasing an asset that costs $1,000,000. The asset, if purchased, will be depreciated on a straight-line basis over six years to a zero residual value. Ace Leasing company is willing to lease the asset for $300,000 per year; the first payment on the lease is due at the time the lease is undertaken (i.e., year 0), and the remaining five payments are due at the beginning of years 1–5. Your company has a tax rate of 40 percent and can borrow at 10 percent from its bank.

(a) Recommend if your company should lease or purchase the asset?

(b) Compute the maximum lease payment your company would agree to pay

Answer 1

a]

Net advantage of leasing is the NPV of the lease relative to the purchase.

This is calculated by calculating the present value of the advantage each year.

Advantage each year = Cash flow with leasing - cash flow with buying.

Buying :

Cash outflow in year 0 = cost of equipment.

Cash inflow in each year = annual depreciation * tax rate (The depreciation is a tax-deductible expense, and hence provides a depreciation tax shield. This is treated as a cash inflow).

Annual depreciation tax shield = (cost of equipment / depreciable life) * tax rate = ($1,000,000 / 6) * 40% = $66,667

Leasing :

Net cash outflow with leasing = lease payment * (1 - tax rate) = $300,000 * (1 - 40%) = $180,000.

NPV of leasing vs buying

Advantage each year = Cash flow with leasing - cash flow with buying.

Present value factor (discount factor) each year = 1 / (1 + discount rate)^year.

Discount rate = after-tax cost of borrowing = interest rate on borrowing * (1 - tax rate) = 10% * (1 - 40%) = 6%.

Net Advantage of leasing each year = advantage amount * discount factor.

NPV of the lease relative to the purchase = -$212,940

As the Net Advantage of Leasing (NAL) is negative, the asset should be purchased, and not leased.

b]

Maximum lease payment is the lease payment where NAL is negative.

We calculate the maximum lease payment using GoalSeek in Excel

maximum lease payment is $227,827