Question

A company wants to purchase a new network file server for its wide-area computer network. The server costs $75,000, and will be completely obsolete in three years and worthless. If the company purchases the server, it can borrow the money at 10% and the server will be depreciated straight line to zero over three years, If the company leases the equipment they will make payments of $27,000 per year, payable at the end of each of the next three years.

The company's tax rate is 34%. What is: the NPV of leasing, the NPV of owning, and the maximum lease payment that the company would be willing to make?

Answer 1

Buying :

Cash outflow in year 0 = cost of equipment.

Cash inflow in each year = annual depreciation * tax rate (The depreciation is a tax-deductible expense, and hence provides a depreciation tax shield. This is treated as a cash inflow).

Annual depreciation tax shield = (cost of equipment / depreciable life) * tax rate = ($75,000 / 3) * 34% = $8,500.

Leasing :

Net cash outflow with leasing = lease payment * (1 - tax rate) = $27,000 * (1 - 34%) = $17,820

Discount rate = after-tax cost of borrowing = interest rate on borrowing * (1 - tax rate) = 10% * (1 - 34%) = 6.6%.

NPV is calculated using NPV function in Excel

NPV of buying is -$52,529

NPV of leasing is -$47,109

The maximum lease payment is where the NPV of leasing equals the NPV of buying.

Maximum after-tax lease payment is calculated using PMT function in Excel :

rate = 6.6% (discount rate)

nper = 3 (number of years)

pv = 52529 (NPV of buying)

PMT is calculated to be $19,870

Maximum before-tax lease payment = maximum after-tax lease payment / (1 - tax rate)

Maximum before-tax lease payment = $19,870 / (1 - 34%)

Maximum before-tax lease payment = $30,106

The maximum lease payment that the company would be willing to make is $30,106