Question

The lessee's lease analysis

Consider the case of Hack Wellington Co. (HWC):

Hack Wellington Co. (HWC) is considering the purchase of new manufacturing equipment that will cost $15,000 (including shipping and installation). HWC can take out a four-year, $15,000 loan to pay for the equipment at an interest rate of 3.60%. The loan and purchase agreements will also contain the following provisions:

•	The annual maintenance expense for the equipment is expected to be $150.
•	The equipment has a four-year depreciable life. The Modified Accelerated Cost Recovery System’s (MACRS) depreciation rates for a three-year asset are 33.33%, 44.45%, 14.81%, and 7.41%, respectively.
•	The corporate tax rate for HWC is 45%.

Note: Hack Wellington Co. (HWC) is allowed to take a full-year depreciation tax-saving deduction in the first year.

Based on the preceding information, complete the following tables:

	Value
Annual tax savings from maintenance will be: a. $143 b. $68 c. $75 d. $31

	Year 1	Year 2	Year 3	Year 4
Tax savings from depreciation
Net cash flow

Thus, the net present value (NPV) cost of owning the asset will be:

$10,666

-$8,816

-$8,315

-$20,476

Hack Wellington Co. (HWC) has been offered an operating lease on the same equipment. The four-year lease requires end-of-year payments of $600, and the firm will have the option to buy the asset in four years for $3,300. The firm will want to use the equipment longer than four years, so it plans to exercise this option. All maintenance will be provided by the lessor. What is the NPV cost of leasing the asset?

-$952

-$14,048

-$4,308

-$5,385

Should HWC lease or buy the equipment?

Lease

Buy

Answer 1

Ans. 1 Annual Tax savings from the maintenance would be = Maintenance cost * tax rate

= 150 * 45%

= 67.5 i.e. approximately = 68

So, the answer is “B”.

Ans 2.

Workings: -

1.

Depreciation Schedule
Years	Depreciation rate	Beginning value	Depreciation amount	Ending Value
1	33.33%	15000	4999.5	10000.5
2	45.45%	10000.5	4545.22725	5455.27275
3	14.81%	5455.27	807.925487	4647.344513
4	7.41%	4647.34	344.367894	4302.972106

2. Cash Outflow Schedule under loan taken @ 3.6% of $15000.

Outflows - loans
Particulars	Years
1	2	3	4
A. Depreciation	4999.5	4545.22	807.92	344.37
B. Interest Expenses	540	540	540	540
C. Maintenance expenses	150	150	150	150
D. Total Expenses	5689.5	5235.22	1497.92	1034.37
E. Annual Tax savings	2560.275	2355.849	674.064	465.4665
F. Depreciation	4999.5	4545.22	807.92	344.37
G. Cash Outflow (D-E-F)	-1870.275	-1665.849	15.936	224.5335
H. Repayment of Loans	0	0	0	15000
I. Total Cash Outflows	-1870.275	-1665.849	15.936	15224.5335

Calculation of NPV-

= -1870.27/(1+r) + -1665.85/(1+r)² + 15.94/(1+r)³+ 15224.54/(1+r)⁴

=

So the answer is “xx”

                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               

3. Cash Outflow Schedule under operating lease of 4 years.

Outflows - Leases

Particulars	Years
1	2	3	4
A. Lease payments	600	600	600	600
B. Purchase Cost	0	0	0	3300
C. Total Cost Incurred	600	600	600	3900

Calculation of NPV-

= 600/(1+r) + (600/1+r)² + (600/1+r)³ + (3900/1+r)⁴

=

So, while comparing cost and benefit analysis HWC should buy *****. As the cost of buying xxxxx is cheaper than the xxxx.

Please provide me the required rate of return so that i can update the answer, or you can also try doing that by applying "r" in the above formula to get the answer

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Thanks.