Question

Lessee Analysis

Nico Engineering (NE), a small machine shop, is considering acquiring a new machine that costs $45,000. Arrangements can be made to lease the machine or to borrow the necessary funding and purchase the machine. The firm is in the 40% tax bracket.

Lease: NE would obtain a 5-year lease from Shelly Worldwide (SW) financing house requiring annual beginning-of-year lease payments of $11,000. All maintenance costs would be paid (year-end) by the lessor, and insurance and other costs would be borne by the lessee. The lessee would exercise its option to purchase the machine for $2,250 at termination of the lease.

Borrow & Buy: NE would finance the purchase of the machine with a 9%, 5-year loan requiring end-or-year installment payments. The machine would be depreciated under MACRS using a 5-year recovery period. NE would pay $1,500 per for a service contract that covers all maintenance costs; insurance and other costs would be borne by the firm. NE plans to keep the machine and use it beyond its 5-year recovery period.

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

using the applicable MACRS 5 year recovery period
cost of asset		45000		tax rate	40%
year	Depreciation %		Depreciation		Tax benefit on depreciation
1	20%		9000		3600
2	32%		14400		5760
3	19%		8550		3420
4	12%		5400		2160
5	12%		5400		2160

Annual lease payment = cost of asset/ PVAF (9%,5years) = 45000 / 3.88965 = $11569

			Payments		End of year Principal
End of year	Loan payments	Begining of year principal	Interest	Principal		Tax benefit on Interest
			(2) * 9%	(1) - (3)	(2) - (4)
	(1)	(2)	(3)	(4)	(5)
1	11569	45000.00	4050.00	7519.00	37481.00	1620.00
2	11569	37481.00	3373.29	8195.71	29285.29	1349.32
3	11569	29285.29	2635.68	8933.32	20351.97	1054.27
4	11569	20351.97	1831.68	9737.32	10614.64	732.67
5	11569	10614.64	954.36	10614.64	0.00	381.74

after-tax cash flow and PV of the lease alternative

the firms after tax cost of debt is 5.4% [9% (1-40%)]

to reflect both flotation costs associated with selling new debt and possible need to sell the debt at a discount, we use an after tax cost of debt 6% for discounting

	(11000 - 40%)		Present value of cash outflows
year	After tax cash flow	PVF@6%
0	6600	1	6600.00
1	6600	0.943	6223.80
2	6600	0.89	5874.00
3	6600	0.84	5544.00
4	6600	0.792	5227.20
5	2250	0.747	1680.75
			31149.75

$2250 is the cost of exercising purchase option at the end of lease term

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

							After tax cash outflow		Present value of cash outflows
	Loan payments	Maintenance costs	Depreciation	Interest	Total deductions	Tax shields
year					(2) +(3) +(4)	(5) * 40%	(1) +(2) -(6)	PVF@6%
	(1)	(2)	(3)	(4)	(5)	(6)	(7)
1	11569	1500	9000	4050.00	14550.00	5820.00	7249.00	0.943	6835.81
2	11569	1500	14400	3373.29	19273.29	7709.32	5359.68	0.89	4770.12
3	11569	1500	8550	2635.68	12685.68	5074.27	7994.73	0.84	6715.57
4	11569	1500	5400	1831.68	8731.68	3492.67	9576.33	0.792	7584.45
5	11569	1500	5400	954.36	7854.36	3141.74	9927.26	0.747	7415.66
									33321.61

Since present value of cash outflows is less in leasing option it'll be selected and is less by 2171.86 (33321.61-31149.75)