Question

Question 3 Freedom Ltd is considering whether to lease or buy an advanced machine for its new product. The following information is available for this decision: Buy: The purchase price of the machine is $4.85 million. The machine will be depreciated using straight-line method over 4 years with a zero salvage value. Lease: The annual lease payments will be $1.1 million, payable at the beginning of each of the four years of the lease. The annual interest rate of secured debt is 11.67%. The corporate tax rate is 40%.

(a) Should the firm lease or buy the machine? Why? (Show your calculations).

(b) Calculate the maximum amount of lease payment that Freedom Ltd is willing to pay. (Show your calculations).(4marks)

Answer 1

It is assumed that $4.85 will be borrowed at 11.67% and will be repaid by equated annual installments

Equated Insatallemt = $4.85 million / 3.058 = $1,586,004

Table Showing Interest and Principal repayment

Year	Installment	Interest	Principal repayment	Closing Balance
1	$1,586,004	$565,995	$1,020,009	$3,829,991
2	$1,586,004	$446,960	$1,139,044	$2,690,947
3	$1,586,004	$314,034	$1,271,970	$1,418,977
4	$1,586,004	$165,595	$1,420,409	-$1,432

-$1432 is because of rounding and is ignored

Present Value of Cash Outflows when machine is purchased.

	Year	1	2	3	4
1	Interest	$565,995	$446,960	$314,034	$165,595
2	Depreciation	$1,212,500	$1,212,500	$1,212,500	$1,212,500
		$1,778,495	$1,659,460	$1,526,534	$1,378,095
3	Tax Shield @ 40%	$711,398	$663,784	$610,614	$551,238
4	Principal Repayment	$1,020,009	$1,139,044	$1,271,970	$1,420,409
	Net Cash Outflows (1 + 4 - 3)	$874,606	$922,220	$975,390	$1,034,766
	PVF @ 11.67%	0.895	0.802	0.718	0.643
	Present Value	$782,772	$739,620	$700,330	$665,355
	PV of Cash Flows	$2,888,078

Table Showing Present Value of Cash flows if machine is leased.

	Year	0	1	2	3
1	Lease Rent	$1,100,000	$1,100,000	$1,100,000	$1,100,000
2	Tax Shield @ 40%	$440,000	$440,000	$440,000	$440,000
3	Net Cash Outflows (1 - 2)	$660,000	$660,000	$660,000	$660,000
	PVF @ 11.67%	1.000	0.895	0.802	0.718
	Present Value	$660,000	$590,700	$529,320	$473,880
	PV of Cash Flows	$2,253,900

As we can see that the present value of cash outflows is lower in the lease optiion the company should go for lease.

Maximum amount of lease rental will be such when its present value will be equal to the present value of buy option which is $2,888,078

Maximum Lease Rent (post tax) = $2,888,078 / 3.415 = $845,703.56

Maximum Lease Rent (pre tax) = $845,703.56 / (1- .40) = $1,409,505.93