Tom Hagstrom needs a new car for his business. One alternative is to purchase the car...

Tom Hagstrom needs a new car for his business. One alternative is to purchase the car outright for $28,000 and to finance the car with a bank loan for the net purchase price. The bank loan calls for 36 equal monthly payments of $881.30 at an interest rate of 8.3% compounded monthly. Payments must be made at the end of each month. The terms of each alternative are Buy Lease $28,000 $696 per month 36-month open-end lease. Annual mileage allowed = 15,000 miles If Tom takes the lease option, he is required to pay $500 for a security deposit, which is refundable at the end of the lease, and $696 a month at the beginning of each month for 36 months. If the car is purchased, it will be depreciated according to a five-year MACRS property classification. The car has a salvage value of $15,400, which is the expected market value after three years, at which time Tom plans to replace the car, irrespective of whether he leases or buys. Tom’s marginal tax rate is 28%. His MARR is known to be 13% per year. (a) Determine the annual cash flows for each option. (b) Which option is better?

Expert Solution

Depreciation under purchase option
5 year property classification i.e. 20% depreciation

Annual depreciation	Tax saving on deprn
5600 (28000 X 20% )	1568 (5600 X 28%)
5600	1568
5600	1568

	Loan option			Lease option
Month	EMI outflow	salvage value	Tax saving on depreciation	Total cashflow	Lease rental with security deposit
0					-500 (security deposit)
1	-881.3			-881.3	-696
2	-881.3			-881.3	-696
3	-881.3			-881.3	-696
4	-881.3			-881.3	-696
5	-881.3			-881.3	-696
6	-881.3			-881.3	-696
7	-881.3			-881.3	-696
8	-881.3			-881.3	-696
9	-881.3			-881.3	-696
10	-881.3			-881.3	-696
11	-881.3			-881.3	-696
12	-881.3		1568	686.7	-696
13	-881.3			-881.3	-696
14	-881.3			-881.3	-696
15	-881.3			-881.3	-696
16	-881.3			-881.3	-696
17	-881.3			-881.3	-696
18	-881.3			-881.3	-696
19	-881.3			-881.3	-696
20	-881.3			-881.3	-696
21	-881.3			-881.3	-696
22	-881.3			-881.3	-696
23	-881.3			-881.3	-696
24	-881.3		1568	686.7	-696
25	-881.3			-881.3	-696
26	-881.3			-881.3	-696
27	-881.3			-881.3	-696
28	-881.3			-881.3	-696
29	-881.3			-881.3	-696
30	-881.3			-881.3	-696
31	-881.3			-881.3	-696
32	-881.3			-881.3	-696
33	-881.3			-881.3	-696
34	-881.3			-881.3	-696
35	-881.3			-881.3	-696
36	-881.3	15400	1568	16086.7	-196 (-696 + 500) (refund of security deposit)

	NPV (1.08333%# , cash flow month1:36)	₹ -813.28		₹ -548.38

# 13% /12 = 1.08333% monthly.

Since the cash outflow under lease option is less than purchase option lease option is better.

ekkarill92 answered 2 years ago

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