Your firm needs $15 million of new manufacturing equipment. If purchased, the equipment will be depreciated...

Your firm needs $15 million of new manufacturing equipment. If purchased, the equipment will be depreciated straight-line over five years, after which you estimate you could sell the equipment for $1.25 million. In this case, you are also responsible for $1 million per year of maintenance costs. If leased, the annual lease payments will be $4.2 million per year for five years (beginning of year payments). Maintenance is included with the lease, but the lease does require a $0.5 million security deposit. The security deposit will be returned at the end of the lease if the asset is returned in acceptable condition (reflecting only normal wear-and-tear).

Your cost of borrowing is 7%, your marginal tax rate is 21%, and the lease qualifies as a true tax lease. What the NPV of the lease vs buy decision and should your firm lease the asset or borrow money to purchase it?

Expert Solution

OPtion 1) Buy the equipment

Statement showing NPV

Particulars	0	1	2	3	4	5	NPV = Sum of PV
Cost of equipment	-15000000
Maintenance cost		-1000000	-1000000	-1000000	-1000000	-1000000
Depreciation (15000000/5)	-3000000	-3000000	-3000000	-3000000	-3000000
PBT		-4000000	-4000000	-4000000	-4000000	-4000000
Tax shield @ 21%		840000	840000	840000	840000	840000
PAT		-3160000	-3160000	-3160000	-3160000	-3160000
Add: Depreciation		3000000	3000000	3000000	3000000	3000000
After tax cash flow		-160000	-160000	-160000	-160000	-160000
Salvage value (1250000(1-tax rate) =1250000(1-0.21) =1250000(0.79) =987500						987500
Total cash flow	-15000000	-160000	-160000	-160000	-160000	827500
PVIF @ 7%	1.0000	0.9346	0.8734	0.8163	0.7629	0.7130
PV	-15000000	-149532.71	-139750.20	-130607.66	-122063.23	589996.06	-14951957.74

Ths NPV = -14,951,957.74 $

Option 2) To lease equipment

Statement showing NPV

Particulars	0	1	2	3	4	5	NPV = Sum of PV
Annual lease	-4200000	-4200000	-4200000	-4200000	-4200000
Tax shield @21%	882000	882000	882000	882000	882000
After tax annual lease	-3318000	-3318000	-3318000	-3318000	-3318000
Security seposit	-500000					500000
Total cash flow	-3818000	-3318000	-3318000	-3318000	-3318000	500000
PVIF @ 7%	1	0.9346	0.8734	0.8163	0.7629	0.7130
PV	-3818000	-3100934.58	-2898069.70	-2708476.36	-2531286.31	356493.09	-14700273.86

NPV of leasing option = -14,700,273.86 $

Thus it is better to lease the equipment rather to buy it as NPV of leasing option is less costly than buying option

jeff jeffy answered 1 year ago

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