Question

Kaiser Permanente must install a new $1.5 million computer to track patient records in its multiple service areas. It plans to use the computer for only three years, at which time a brand new system will be acquired that will handle both billing and patient records. The company can obtain a 10 percent bank loan to buy the computer or it can lease the computer for three years. Assume that the following facts apply to the decision:

- The computer falls into the three-year class for tax depreciation, so the MACRS allowances are 0.33, 0.45, 0.15, and 0.07 in Years 1 through 4, respectively.

- The company's marginal tax rate is 34 percent.

-Tentative lease terms call for payments of $500,000 at the end of each year.

- The best estimate for the value of the computer after three years of wear and tear is $500,000.

What are the NAL and IRR of the lease? Should the computer system be purchased?

Please show work in Excel

Answer 1

The cash flows of the buying option are :

Year 0 = purchase price = $1,500,000

Year 1 = Tax shield on depreciation = purchase price * MACRS depreciation rate for year 1 * tax rate

Year 2 = Tax shield on depreciation = purchase price * MACRS depreciation rate for year 2 * tax rate

Year 3 = Tax shield on depreciation + after-tax salvage value

after-tax salvage value = before-tax salvage value - tax on salvage value

tax on salvage value = (salvage value - book value) * tax rate

book value = purchase price - total depreciation = $1,500,000 - ($1,500,000 * 92%) = $120,000

tax on salvage value = ($500,000 - $120,000) * 34% = $129,200

after-tax salvage value = $500,000 - $129,200 = $370,800

The cash flows of the leasing option are :

Years 1 to 3 :

Lease payment * (1 - tax rate)

Advantage each year = cash flow of leasing option - cash flow of buying option

The discount factor for each year is calculated using 10% discount rate, which is the rate of the loan

The IRR of the leasing option is calculated using IRR function in Excel, and the values being the advantage of each year

The NAL is calculated as the sum of each year's (advantage * discount factor)

NAL is $606.31

IRR is 9.98%