Question

Lessee Analysis

Craxton Engineering will either purchase or lease a new $756,000 fabricator. If purchased, the fabricator will be 100% funded with a 12 percent loan that is amortized with end-of-year payments over five years and it will be depreciated using a MACRS 5-year schedule. Craxton will be responsible for maintenance of the equipment. A service contract covering parts and labor is available from the manufacturer for a $18,000 end-of-year payment. Alternative to purchasing, Craxton can lease the fabricator for beginning-of-year annual payments of $190,000 for five years with the lessor responsible for maintenance. In either alternative of purchasing or leasing, Craxton will be responsible for the insurance of the fabricator. It is estimated that the insurance is $2,500 per year. Craxton’s tax rate is 40%. Assume the fabricator has no residual value at the end of the five years.

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 = 756000*0.12*1.12^5/(1.12^5-1) =	209722
	Interest rate for discounting = 12*(1-40%) =	7.20%
		0	1	2	3	4	5
1)	Depreciation % (MACRS)		20.00	32.00	19.20	11.52	11.52
	Depreciation		$     1,51,200	$       2,41,920	$      1,45,152	$        87,091	$       87,091
2)	Beginning balance of loan		$     7,56,000	$       6,36,998	$      5,03,716	$    3,54,440	$   1,87,250
	Interest at 12%		$         90,720	$           76,440	$         60,446	$        42,533	$       22,470
	Total		$     8,46,720	$       7,13,438	$      5,64,162	$    3,96,972	$   2,09,720
	Installment		$     2,09,722	$       2,09,722	$      2,09,722	$    2,09,722	$   2,09,720
	Ending balance		$     6,36,998	$       5,03,716	$      3,54,440	$    1,87,250	$                 0
	Depreciation under MACRS		$     1,51,200	$       2,41,920	$      1,45,152	$        87,091	$       87,091
3)	PV OF LEASING:
	After tax lease payments =190000*(1-40%) =	$    -1,14,000	$   -1,14,000	$     -1,14,000	$    -1,14,000	$   -1,14,000	$                -
	After tax cash flows from leasing	$    -1,14,000	$   -1,14,000	$     -1,14,000	$    -1,14,000	$   -1,14,000	$                -
	PVIF at 7.20% [PVIF = 1/1.072^n]	1	0.93284	0.87018	0.81174	0.75722	0.70636
	PV at 7.20%	$    -1,14,000	$   -1,06,343	$         -99,201	$        -92,538	$      -86,323
	PV of leasing	$    -4,98,405
4)	Cash flows of buying:
	Principal repayment		$   -1,19,002	$     -1,33,282	$    -1,49,276	$   -1,67,189	$ -1,87,250
	After tax interest [Interest * (1-40%)]		$       -54,432	$         -45,864	$        -36,268	$      -25,520	$     -13,482
	After tax maintenance fee = 18000*(1-40%)		$       -10,800	$         -10,800	$        -10,800	$      -10,800	$     -10,800
	Tax shield on loss on scrapping = 53546*40% =						$       21,418
	Tax shield on depreciation		$         60,480	$           96,768	$         58,061	$        34,836	$       34,836
	After tax cash flows from buying		$   -1,23,754	$         -93,178	$    -1,38,283	$   -1,68,672	$ -1,55,277
	PVIF at 7.20% [PVIF = 1/1.072^n]		0.93284	0.87018	0.81174	0.75722	0.70636
	PV at 7.20%		$   -1,15,442	$         -81,082	$    -1,12,249	$   -1,27,722	$ -1,09,682
	NPV of buying	$    -5,46,177
5)	NAL of leasing = -498405-(-561306) =	$         47,772
6)	Leasing is recommended at the NAL of leasing is positive.
	Note:
	Insurance is not included, as it is the same for both the alternatives.