Question

Lessee Analysis

Riverton Mining plans to purchase or lease $330,000 worth of excavation equipment. If purchased, the equipment will be depreciated on a straight-line basis over three years, after which it will be worthless. A 100% amortized 3-year loan with end-of-year payments will be used. If leased, the annual beginning-of-year lease payments will be $105,000 per year for three years. Assume Riverton’s borrowing cost is 8%, its tax rate is 35%. Maintenance and service is the responsibility of Riverton Mining regardless if the equipment is leased or purchased. The equipment supplier offers a maintenance and service contract for $25,000 per year payable at the beginning of each year.

You are required to:

1. Prepare the Depreciation Schedule.

2. Prepare the Loan Amortization Table.

3. Find the after-tax cash flow and PV of the lease alternative.

4. Find the after-tax cash flow and PV of the borrow & buy alternative.

5. Explain which alternative you would recommend giving your reasons.

Answer 1

	Annual installments of the loan = 330000*0.08*1.08^3/(1.08^3-1) =	$ 128051
	Interest rate for discounting = 8*(1-35%) =	5.20%
		0	1	2	3
1)	Depreciation (330000/3)		$     1,10,000	$       1,10,000	$      1,10,000
2)	Loan amortization schedule:
	Beginning balance of loan		$     3,30,000	$       2,28,349	$      1,18,566
	Interest at 8%		$         26,400	$           18,268	$            9,485
	Total		$     3,56,400	$       2,46,617	$      1,28,051
	Installment		$     1,28,051	$       1,28,051	$      1,28,051
	Ending balance		$     2,28,349	$       1,18,566	$                    0
3)	PV OF LEASING:
	After tax lease payments = 105000*(1-35%) =	$        -65,000	$       -65,000	$         -65,000	0
	PVIF at 5.20% [PVIF = 1/1.052^n]	$                    1	0.95057	0.90358	0.85892
	PV at 5.20%	$        -65,000	$       -61,787	$         -58,733	$                   -
	NPV of leasing	$    -1,85,520
4)	Cash flows of buying:
	Principal repayment		$   -1,01,651	$     -1,09,783	$    -1,18,566
	After tax interest [Interest * (1-35%)]		$       -17,160	$         -11,874	$          -6,165
	Tax shield on depreciation		$         38,500	$           38,500	$         38,500
	After tax cash flows from buying		$       -80,311	$         -83,157	$        -86,231
	PVIF at 5.20% [PVIF = 1/1.052^n]		0.95057	0.90358	0.85892
	PV at 5.20%		$       -76,341	$         -75,140	$        -74,066
	NPV of buying	$    -2,25,547
5)	NAL OF LEASING = -185520-(-225547) =	$         40,027
	Leasing is recommended as the NAL of leasing is positive.
	Note:
	Maintenance and service cost is not included as it is the same for both the alternatives.