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Lease versus purchase: JLB Corporation is attempting to determine whether to lease or purchase research equipment....

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 ___

Solutions

Expert Solution

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

jeff jeffy answered 2 years ago
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