Question

A company is considering whether to lease or purchase some specialized equipment. The capital budgeting analysis indicating the equipment should be secured already has not been completed. The equipment has a five-year economic and tax life, and the company uses a straight-line depreciation method. The equipment costs $1,000,000 if purchased or it can be leased for five-years at $280,000 per year. The first lease payment is payable in advance. The equipment’s salvage value is estimated to be $100,000. Revenue is expected to be $350,000. Given that the firm has a marginal tax rate of 30% and an after-tax weighted average cost of capital of 10%,

 Determine the net advantage of leasing.

 Should the firm lease or purchase?

 Would the NAL be higher/lower if you used the after-tax cost of debt?

Answer 1

Based on the given data, pls find below workings, steps and answers highlighted in yellow:

Based on the data, the NPV of Buy option is higher than that of the Lease option; Hence, there is actually Net Loss if we leasing option is chosen in this case;

1) Net Advantage of Leasing is negative $ 27773

2) Hence, the firm should go for purchasing the equipment rather than leasing the same;

3) It is not possible to comment on the NAL with out knowing the actual after tax cost of debt;

Computation of Net Present Value (NPV) based on the Discounted Cash flows; The Discounting factor is computed based on the formula: For year 0, the discounting factor is 1; For Year 1, it is computed as = Year 0 factor /(1+discounting factor%) ; Year 2 = Year 1 factor/(1+discounting factor %) and so on;

Next, the cashflows need to be multiplied with the respective years' discounting factor, to arrive at the discounting cash flows;

The total of all the discounted cash flows is equal to its respective Project NPV of the Cash Flows;