Question

Riverton Mining plans to purchase or lease $435,000 worth of excavation equipment. If purchased, the equipment will be depreciated on a straight-line basis over five years, after which it will be worthless. If leased, the annual lease payments will be $101,169 per year for five years. Assume Riverton's borrowing cost is 7.5%, its tax rate is 30%, and the lease qualifies as a true tax lease.

a.) If Riverton purchases the equipment, what is the amount of the lease-equivalent loan?

The amount of the lease-equivalent loan is___________ $. (Round to the nearest dollar.)

b.) Is Riverton better off leasing the equipment or financing the purchase using the lease-equivalent loan?

Riverton is better off ___________. (Fill in either "financing the purchase" or "leasing the equipment")

c.) What is the effective after-tax lease borrowing rate? How does this compare to Riverton's actual after-tax borrowing rate?

The effective after-tax lease borrowing rate is_____________ %. (Round to two decimal places.)

Answer 1

	After tax cost of debt	7.5%*(1-30%)	5.25%
	Depreciation each year	435000/5	87000
	Leasing
	Yr	1	2	3	4	5
	Lease cash flow	101,169.00	101,169.00	101,169.00	101,169.00	101,169.00
	Tax shield @ 30%	30,350.70	30,350.70	30,350.70	30,350.70	30,350.70
	Aftex tax CF	70,818.30	70,818.30	70,818.30	70,818.30	70,818.30
a)	Lease equivalent loan = NPV @ 5.25%	$304,499
b)	If going for purchase option
	Yr	1	2	3	4	5
	Depreciation	$87,000.00	$87,000.00	$87,000.00	$87,000.00	$87,000.00
	Interest	$32,625.00	$32,625.00	$32,625.00	$32,625.00	$32,625.00
	Total	$119,625.00	$119,625.00	$119,625.00	$119,625.00	$119,625.00
	Tax shield @ 30%	$35,887.50	$35,887.50	$35,887.50	$35,887.50	$35,887.50
	Aftex tax CF	($3,262.50)	($3,262.50)	($3,262.50)	($3,262.50)	($3,262.50)
	Loan paid back					$435,000.00
	Total	($3,262.50)	($3,262.50)	($3,262.50)	($3,262.50)	$431,737.50
	NPV @ 5.25%	$322,777
c)	Since NPV of lease is less, it is better off leasing
d)	Lease rate
	Cash flow	($322,777)	70,818.30	70,818.30	70,818.30	70,818.30	70,818.30
	Lease rate = IRR	3.17%
	It is less than after tax cost of debt