Question
In: Finance
Freedom Ltd is considering whether to lease or buy an advanced machine for its new product....
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).
Solutions
Expert Solution
| PURCHASE OPTION | |||||||||||
| Equipment Cost | $4,850,000 | ||||||||||
| Annual Depreciation=4850000/4= | $1,212,500 | ||||||||||
| Annual Depreciation Tax shield=1212500*40% | $485,000 | ||||||||||
| INTEREST AND PRINCIPAL REPAYMENT ON AMOUNT BORROWED | |||||||||||
| Pv | Amount Borrowed = | $4,850,000 | |||||||||
| Nper | Number of years of repayment | 4 | |||||||||
| Rate | Interest Rate | 11.67% | |||||||||
| PMT | Annual repayment in four equal instalments | $1,585,703 | (Using PMT function of excelwith Rate=11.67%,Nper=4, Pv=-4850000 | ||||||||
| REPAYMENT SCHEDULE | |||||||||||
| Year | 1 | 2 | 3 | 4 | |||||||
| A | Beginning Balance | $4,850,000 | $3,830,292 | $2,691,585 | $1,419,990 | ||||||
| B | Amount of annual payment | $1,585,703 | $1,585,703 | $1,585,703 | $1,585,703 | ||||||
| C=A*17% | Interest | $565,995 | $446,995 | $314,108 | $165,713 | ||||||
| D=B-C | Principal | $1,019,708 | $1,138,708 | $1,271,595 | $1,419,990 | ||||||
| E=A-D | Ending Balance | $3,830,292 | $2,691,585 | $1,419,990 | $0 | ||||||
| After tax interest =11.67*(1-0.4)= | 7.00% | ||||||||||
| Present Value of Cash Flow=(Cash Flow)/((1+i)^N) | |||||||||||
| i=discount rate =after tax cost of debt=7%=0.07 | |||||||||||
| N=Year of cash flow | |||||||||||
| N | Year | 0 | 1 | 2 | 3 | 4 | |||||
| Annual Cash Inflows: | |||||||||||
| a | Annual Interest Payment | $565,995 | $446,995 | $314,108 | $165,713 | ||||||
| b=a*(1-0.4) | After Tax Interest Cost for amount borrowed | -$339,597 | -$268,197 | -$188,465 | -$99,428 | ||||||
| c | Depreciation Tax shield | $485,000 | $485,000 | $485,000 | $485,000 | ||||||
| d | Payment of Principal | -$1,019,708 | -$1,138,708 | -$1,271,595 | -$1,419,990 | ||||||
| CF=b+c+d | Total Cash Flow | -$874,305 | -$921,905 | -$975,060 | -$1,034,418 | SUM | |||||
| PV=CF/(1.07^N) | Present Value of Cash Flow | -$817,107 | -$805,227 | -$795,939 | -$789,152 | -$3,207,426 | |||||
| NET PRESENT VALUE(NPV) of COSTS OF PURCHASE | -$3,207,426 | ||||||||||
| LEASE OPTION | |||||||||||
| After tax lease payment =1100000*(1-0.4) | $660,000 | ||||||||||
| N | Year | 0 | 1 | 2 | 3 | 4 | |||||
| .(1) | After Tax Lease Payment | -$660,000 | -$660,000 | -$660,000 | -$660,000 | ||||||
| CF | Total Cash Flow | -$660,000 | -$660,000 | -$660,000 | -$660,000 | $0 | SUM | ||||
| PV=CF/(1.07^N) | Present Value of Cash Flow |
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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...
Freedom Ltd is considering whether to lease or buy an advanced machine for its new product....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...
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