Question

Question 3 – Leasing

Suppose Procter and Gamble (P&G) is considering purchasing $15 million new manufacturing equipment. If it purchases the equipment, it will depreciate it on a straight-line basis over the five years, after which the equipment will be worthless. It will also be responsible for maintenance expenses of $1 million per year. Alternatively, it can lease the equipment for $4.2 million per year for the five years, in which case the lessor will provide necessary maintenance. Assume P&G’s tax rate is 35% and its borrowing cost is 7%.

Required:

1. What is the NPV associated with leasing the equipment versus financing it with the lease equivalent loan?
2. What is the break-even lease rate—that is, what lease amount could P&G pay each year and be indifferent between leasing and financing a purchase?

Answer 1

a. If P&G buys the equipment, it will pay $15 million upfront, and have depreciation expenses of $3 million per year, generating a depreciation tax shield of $1.05 (35%*$3) million per year for year 1 to 5.

The company will also have after tax maintenance expense of $0.65 million [$1 x (1-0.35)] per year.

Therefore, the Free Cash Flows (FCF) from buying the equipment is 0.40 million $(1.05 - 0.65) per year from year 1 to 5.

On the other hand, if the company leases the equipment, the after tax lease payment will be $2.73 million [$4.2 x (1-0.35)] per year.

Hence, the Free Cash Flows (FCF) from leases vs buying will be as follows:

Year 0 = -$2.73-(-$15) = $12.27 million

Year 1 to Year 4 = $(-2.73-0.40) = -$3.13 million

Year 5 = $(0-0.40) = -$0.40 million

NPV (Lease vs Buying) = $733,955

Hence, Lease is more attractive than financing a purchase of equipment.

b. We can increase the after-tax lease payments by an amount with present value equal to the NPV in (a). Therefore,

Increase in lease will be 246,363. Therefore, the break-even lease rate is 4.2+0.246363 = $4.446363 million per year, as presented in the following excel format:

Buy	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Capex	-15,000,000	0	0	0	0	0
After tax maintenance		-650,000	-650,000	-650,000	-650,000	-650,000
Depreciation tax shield @ 35%		1050000	1050000	1050000	1050000	1050000
Free cash flow (Buy)	-15,000,000	400,000	400,000	400,000	400,000	400,000
Lease
Lease payments	-4,446,363	-4,446,363	-4,446,363	-4,446,363	-4,446,363	0
Income tax savings @ 35%	1,556,227	1,556,227	1,556,227	1,556,227	1,556,227	0
Free cash flow (Lease)	-2,890,136	-2,890,136	-2,890,136	-2,890,136	-2,890,136	0
Lease vs Buy	12,109,864	-3,290,136	-3,290,136	-3,290,136	-3,290,136	-400,000
NPV	$0