Question

Along with the business, however, Paulo inherited some worn out equipment, which surely had “seen better days.” Paulo was sick and tired of making frequent phone calls to the service company for equipment repairs and maintenance work. As a result, the restaurant service quality was beginning to deteriorate and profits were being hurt. In particular, three ovens, a dishwasher, and a pasta machine needed to be replaced. The total cost of the equipment including delivery and installation was estimated to be $100,000, 3-year Modified Accelerated Cost Recovery schedule rates could be used to depreciate the equipment.

Now if were Papa Rossi at the helm, there would have been enough cash in the coffer to buy the equipment outright. However, under Paulo, the cash balance of the firm had shrunk miserable. The problem with Paulo was that unlike his father, he enjoyed a much more lavish lifestyle. The flashy sports car, penthouse, and boat were paid in full from business profits, leaving not much cash for business renovation and equipment replacement. On numerous occasions, Papa Rossi had tried to counsel his son on the benefits of being thrifty but to no avail. Young Paulo preferred to live for today.

Thanks to Papa Rossi’s conservative ways the credit rating of the restaurant had been exemplary. The money for the equipment could be easily borrowed from their bank at a rate of 10% per year over a 5-year term. However, Paulo had heard from his business colleague that in some cases it is better to lease than to buy. Many of his colleagues claimed that they were already enjoying significant benefits as a result of having leased business assets.

After checking around and calling various leasing companies, Paulo found that he could lease the needed equipment and appliances from AAA Leasing Company for an annual lease payment of $25,000 over a 5- year term, payable at the end of each year. Maintenance costs would be covered by the annual lease payment. If purchased, maintenance costs on the new equipment were estimated to be $2,000 per year which are payable at the end of each year and fully tax-deductible.

Paulo, being fully aware of his father’s dislike for debt, was seriously thinking about leasing the equipment. However, not being fully conversant with all the pros and cons of leasing versus borrowing and buying, there were a number of questions that Paulo needed to answer for. Above all, he was curious about AAA Leasing Company’s main slogan, which read “Why buy it if you can lease it?”

Calculate the net advantage to leasing (NAL) the restaurant equipment. It is assumed that old equipment would have a salvage value of $30,000 after 5 years. The restaurant’s tax rate is estimated to be 40%.

Answer 1

All the financials below are in $.

MACRS depreciation schedule: 33%, 45%, 15%, 7%

New Equipment cost		$100,000
New Equipment life		5
Equip. Residual Value		$30,000
Tax Rate		40%
Loan interest rate		10%
Annual rental charge		$25,000
After-tax cost of debt		6%
Maintenance if not leased		$2,000

NPV of Owning:

Year		0	1	2	3	4	5
Equipment cost		($100,000)
Loan amount		$100,000
Interest expense			($10,000)	($10,000)	($10,000)	($10,000)	($10,000)
Tax savings from interest			4000	4000	4000	4000	4000
Principal repayment							($100,000)
After tax loan payment			($6,000)	($6,000)	($6,000)	($6,000)	($106,000)
Depreciation shield			$13,200	$18,000	$6,000	$2,800	$0
Maintenance			($2,000)	($2,000)	($2,000)	($2,000)	($2,000)
Tax savings on maintenance		$0	$800	$800	$800	$800	$800
Residual value							$30,000
Tax on residual value							$12,000
Net cash flow		$0	$6,000	$10,800	($1,200)	($4,400)	($89,200)
PV ownership cost @ 6%		($55,875.845)

NPV of Leasing

Year		0	1	2	3	4	5
Lease payment			($25,000)	($25,000)	($25,000)	($25,000)	($25,000)
Tax savings from lease		$0	$10,000	$10,000	$10,000	$10,000	$10,000
Net cash flow		$0	($15,000)	($15,000)	($15,000)	($15,000)	($15,000)
PV of leasing @ 6%		($63,185.457)

Final comparison
PV ownership cost @ 6%		($55,875.845)
PV of leasing @ 6%		($63,185.457)
Net Advantage to Leasing		($7,309.612)

Hence, NAL = - $ 7,309.612