In: Finance
Lease versus purchase: JLB Corporation is attempting to determine whether to lease or purchase research equipment. The firm is in the 28% tax bracket, and its after-tax cost of debt is currently 9%. The terms of the lease and of the purchase are as follows: Lease: Annual end-of-year lease payments of $28,000 are required over the 3-year life of the lease. All maintenance costs will be paid by the lessor; insurance and other costs will be borne by the lessee. The lessee will exercise its option to purchase the asset for $5,000 at termination of the lease. Ignore any future tax benefit associated with the purchase of the equipment at the end of year 3 under the lease option.
Purchase: The research equipment, costing $65,000 can be financed entirely with a 16% loan requiring annual end-of-year payments of $28,942 for 3 years. The firm in this case will depreciate the equipment under MACRS using a 3-year recovery period. (See (BELOW) for the applicable depreciation percentages.) The firm will pay 1,800 per year for a service contract that covers all maintenance costs; insurance and other costs will be borne by the firm. The firm plans to keep the equipment and use it beyond its 3-year recovery period.
a. The after-tax cash outflow associated with the lease in in year 1 is ___
b. The after-tax cash outflow associated with the lease in in year 2 is ___
c. The after-tax cash outflow associated with the lease in in year 3 is ___
d. The after-tax cash outflow associated with the purchase in in year 1 is ___
e. The after-tax cash outflow associated with the purchase in in year 2 is ___
f. The after-tax cash outflow associated with the purchase in in year 3 is ___
g. The total present value of the after-tax cash outflows associated with the lease is ___
h. The total present value of the after-tax cash outflows associated with the purchase is ___
a. The after-tax cash outflow associated with the lease in in year 1 is -$20161
b. The after-tax cash outflow associated with the lease in in year 2 is -$20161
c. The after-tax cash outflow associated with the lease in in year 3 is -$26161
d. The after-tax cash outflow associated with the purchase in in year 1 is -$21320
e. The after-tax cash outflow associated with the purchase in in year 2 is -$20068
f. The after-tax cash outflow associated with the purchase in in year 3 is -$26424
g. The total present value of the after-tax cash outflows associated with the lease is -$54,894
h. The total present value of the after-tax cash outflows associated with the purchase is -$43023
CALCULATION
Calculation of the After-Tax Cash Flows associates with each alternative, Lease or Buy.
(i) Lease Option :
Year |
Lease Payments (A) |
Tax Benefit on Lease Payments (B = A * 28%) |
Net Annual Cash Flow |
1 |
-$28,000 |
$7,840 |
-$20161 |
2 |
-$28,000 |
$7,840 |
-$20161 |
3 |
-$28,000 |
$7,840 |
-$20161 |
3 |
-$5,000 |
- |
-$5,000 |
(i) Buy Option :
Year |
Payment (A) |
Interest (as per Amortization Table Below) |
Tax Benefit on Interest (B = Interest * 28%) |
Depreciation (C) |
Tax Benefit on Depreciation (D = C * 28%) |
Maintenance Cost (E) |
Tax Benefit on Maintenance Cost (F = E * 28%) |
Net Annual Cash Flow (A+B+D+E+F) |
1 |
-$28,9 42 |
$10,400 |
$2912 |
$21450 |
$6006 |
-$1,800 |
$504 |
-$21320 |
2 |
-$28,9 42 |
$7433 |
$2081 |
$28892 |
$8089 |
-$1,800 |
$504 |
-$20068 |
3 |
-$28,9 42 |
$3,993 |
$1118 |
$9627 |
$2696 |
-$1,800 |
$504 |
-$26424 |
Loan Amortization Table
Year |
Opening Balance |
Payment |
Interest (Opening Balance * 16%) |
Principal Repayment (Payment - Interest) |
Closing Balance (Opening Balance - Principal Repayment |
1 |
$65,000 |
$28,942 |
$10,400 |
$18542 |
$46,458 |
2 |
$46,458 |
$28,942 |
$7433 |
$21,509 |
$24949 |
3 |
$24,949 |
$28,942 |
$3,993 |
$24,949 |
Nil |
Calculation of the Present Value of Cash Outflows, using the after-tax cost of debt.
(i) Lease Option :
Year |
Net Annual Cash Flow |
PVF @ 9% |
Present Value of Annual Cash Flow |
1 |
-$20161 |
0.91743 |
-$18,496 |
2 |
-$20161 |
0.84168 |
-$16969 |
3 |
-$20161 |
0.77218 |
-$15568 |
3 |
-$5,000 |
0.77218 |
-$3,861 |
Present Value of the Total Annual Cash Flows |
-$54,894 |
(ii) Buy Option :
Year |
Net Annual Cash Flow |
PVF @ 9% |
Present Value of Annual Cash Flow |
1 |
-$15,565 |
0.91743 |
-$14280 |
2 |
-$13,873 |
0.84168 |
-$11677 |
3 |
-$22,100 |
0.77218 |
-$17066 |
Present Value of the Total Annual Cash Flows |
-$43023 |