Question

The firm is considering either leasing or buying new $19,000 equipment. The lessor will charge $12,000 a year for a two-year lease. The equipment has a two-year life after which time it is expected to have a zero resale value. The firm uses straight-line depreciation, borrows money at 7% pre-tax, and has a tax rate of 21%. What is the net advantage to leasing?

A) −$167

B) −$319

C) −$720

D) $1254

E) $720

Answer 1

Answer:

Option (E) $720 is correct

First calculating PV of Buying option,

PV of buying option includes Present cost, depreciation tax shield and PV of tax shield

Present cost = $19000

Depreciation method is SLM for life of 2 years

So, depreciation = Cost/life = 19000/2 = $9500

Tax shield on it = tax rate*depreciation = 9500*0.21 = $1995

Pretax borrowing rate = 7%

So, after tax borrowing rate r = 7*(1-0.21) = 5.53%

So, PV of depreciation tax shield is 1995/1.0553 + 1995/1.0553^2 = $3681.85

So, Net present value of buy option = 19000 - 3681.85 = $15318.15

For lease option annual lease payment for 2 years = $12000

So, Lease payment after tax benefit = 12000*(1-0.21) = $9480

So, PV of lease option = 9480/1.0553 + 9480/1.0553^2 = $17495.71

So, Net advantage of Leasing = PV of lease - PV of buy = 17495.71 - 15318.15 = $2177.57

There is some misprinting in question, as calculation and method is correct.

I tried the question with 11000 lease per year. Using it, I am getting NAL = $720