Question

The Chief Financial Officer of ENG Company decided to purchase a warehouse instead of renting it. The CEO wants you to review the facts and decide whether it is the right decision or not. The company could rent the warehouse for $7,500 per year or it could purchase it for $52,500 and use it for years 0 through 7. The warehouse depreciation rate is 15%. ENG has a marginal tax rate of 15% and uses an 8% discount rate to compute NPV.

Answer 1

Since the NPV of Renting option [$33,214 - A] is lower than NPV of buying the warehouse [$48,328 - B] , therefore renting the machine is better than buying it.

Working:

(A) PV of Cash Flow If the CFO rented the machine: $33,214

Annual Cash Flow = (Rent payment )*( 1 - Tax Rate)

= (7,500) * (1 - 0.15)

= (7500 * 0.85)

= 6,375

PV of Annual Cash Flow (0 - 7yrs) = Annual CF * Anuity Fator @8%,7years

= 6,375 * 5.21

= 33,214

(B) PV of Cash Flow If the CFO Purchased the machine : $48,328

Cost of Asset	52,500
Depreciation	15%
Tax Rate	15%
Discount Rate	8%

Year	Cost of asset (A)	Depreciation (B)	Depreciation Tax Shield (C = B*Tax Rate)	DF @ 8%	Present Value of CF
0	-52,500	-	-	1	-52,500
1		7,875	1,181	0.923	1,090
2		6,694	1,004	0.857	860
3		5,690	853	0.794	678
4		4,836	725	0.735	533
5		4,111	617	0.681	420
6		3,494	524	0.631	331
7		2,970	446	0.583	260
				NPV :	-48,328

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