Question

In order to buy an automated packing machine for your factory, the cost would be $150,000. You have inquired at the bank about borrowing that amount and the bank would charge you a rate of 9.5 percent on the loan.

The packing machine would be used for 10 years, at the end of which it would have no salvage value. It falls in an asset class with an allowable CCA rate of 10 percent per year. The use of the machine would reduce before-tax costs by $30,000 per year over its life.

You also have the ability to lease the parking machine from the manufacturer for lease payments of $25,000 per year (due at the end of each year). Your firm’s tax rate is 35%. Assuming that you will obtain the new packing machine in some way, should you lease or buy it?

Answer 1

(i)P.V. of Cash Outflow under lease option:-

Year	Lease Rental after Tax	[email protected]%	Total P.V.
1-10	$25,000(1-T) =16,250	9.5(1-T) =7.299	1,18,609

(ii)Cash Flow Under Borrowing Option:-

Year	Principal(1)	[email protected]%(2)	Total(1+2)=(3)	Depre.(4)@10%	Tax Shield(5) (2+4)*0.35	Cash(6) Outflows (3-5)	(7) P.V.factors @6.175%	(8) P.V.
1	15000	14,250	29,250	15,000	10,238	19,012	0.942	17909
2	15000	12,825	27,825	15,000	9,739	18,086	0.887	16042
3	15000	11,400	26,400	15,000	9240	17160	0.835	14329
4	15000	9975	24,975	15,000	8741	16261	0.787	12797
5	15000	8550	23,550	15,000	8243	15307	0.741	11342
6	15000	7125	22,125	15,000	7744	14381	0.698	10038
7	15000	5700	20,700	15,000	7245	13,455	0.657	8840
8	15000	4275	19275	15,000	6746	12529	0.619	7755
9	15000	2850	17,850	15,000	6248	11,602	0.583	6764
10	15000	1425	16,425	15,000	5749	10,676	0.549	5861
					Total PV Outflows			1,11,677

ADVISE:- Company is Advised to Borrrow and Buy and not to go for leasing as NPV of Cash Outflows is Lower in case of Buying alternative.

Note:- Discount rate is Post Tax Debt Rate is used at which Cash Flows of Both The alternative is dicounted:-