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Lease vs Buy Purchase 10 million Depreciate 5 years straight line to zero Expected salvage 2...

Lease vs Buy

Purchase 10 million

Depreciate 5 years straight line to zero

Expected salvage 2 million

Tax rate 40%

Lease payments 2 million at beginning of year

Cost of equity 10%

Cost of debt 5%

D/E = 1

Cost of capital?

Cost of ownership?

Value of dep tax shield

Value of ownership?

Value of lease?

Solutions

Expert Solution

Cost of capital

Cost of capital = Cost of equity * Weight + After tax cost of debt * Weight

= 10% * 0.5 + 5%(1-0.4) * 0.5

= 6.5%

Cost of ownership

Cost of ownership = Purchase cost- Tax savings on depreciation - Salvage value

= $10 million - (40%*$2 million*5 years) - $2 million

= $4 million

Value of dep tax shield

Year 1 2 3 4 5 Total
Depreciation $             2 $             2 $             2 $             2 $             2 $    10.00
Tax savings @ 40% $       0.80 $       0.80 $       0.80 $       0.80 $       0.80 $       4.00
PVF @ 6.5%           0.94           0.88           0.83           0.78           0.73
Value of dep. tax shield $       0.75 $       0.71 $       0.66 $       0.62 $       0.58 $       3.32

Value of ownership

Year 0 1 2 3 4 5 Total
Purchase cost     (10.00) $ (10.00)
Tax savings @ 40%               -             0.80           0.80           0.80           0.80           0.80 $       4.00
Salvage value               -                  -                  -                  -                  -             2.00 $       2.00
Cost of ownership     (10.00)           0.80           0.80           0.80           0.80           2.80 $    (4.00)
PVF @ 6.5% 1           0.94           0.88           0.83           0.78           0.73
Value of ownership     (10.00)           0.75           0.71           0.66           0.62           2.04 $    (5.22)

Value of lease

Year 0 1 2 3 4 Total
Lease payments          2.00           2.00           2.00           2.00           2.00 $    10.00
PVF @ 6.5% 1           0.94           0.88           0.83           0.78
Value of lease          2.00           1.88           1.76           1.66           1.55 $       8.85

jeff jeffy answered 1 year ago
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