Question

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).

Answer 1

			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	jeff jeffy Next > < Previous Related Solutions 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... 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. 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