Question

Big Sky Mining Company must install $1.5 million of new machinery in its Nevada mine. It can obtain a bank loan for 100% of the purchase price, or it can lease the machinery. Assume that the following facts apply.

• The machinery falls into the MACRS 3-year class (.3333, .4445, .1481. .0741).

• Under either the lease or the purchase, Big Sky must pay for insurance, property taxes, and maintenance.

• The firm’s tax rate is 40%.

• The loan would have an interest rate of 15%. It would be non-amortizing, with only interest paid at the end of each year for four years and the principal repaid at Year 4.

• The lease terms call for $400,000 payments at the end of each of the next 4 years.

• Big Sky Mining has no use for the machine beyond the expiration of the lease, and the machine has an estimated residual value of $250,000 at the end of the 4th year.

What is the NAL (Net advantage to leasing)?

Answer 1

Net advantage of leasing is the NPV of the lease relative to the purchase.

This is calculated by calculating the present value of the advantage each year.

Advantage each year = Cash flow with leasing - cash flow with buying.

Buying :

Cash outflow in year 0 = cost of equipment.

Cash inflow in years 1 to 3 = depreciation * tax rate (The depreciation is a tax-deductible expense, and hence provides a depreciation tax shield. This is treated as a cash inflow).

Cash inflow in year 4 = (depreciation * tax rate) + (residual value * (1 - tax rate))

Leasing :

Net cash outflow with leasing = lease payment * (1 - tax rate) = $400,000 * (1 - 40%) = $240,000.

NPV of leasing vs buying

Advantage each year = Cash flow with leasing - cash flow with buying.

Present value factor (discount factor) each year = 1 / (1 + discount rate)year.

Discount rate = after-tax cost of borrowing = interest rate on borrowing * (1 - tax rate) = 15% * (1 - 40%) = 9%.

Net Advantage of leasing each year = advantage amount * discount factor.

NPV of the lease relative to the purchase = $108,146.69