Question

In: Finance

A cash-strapped firm would like to acquire a capital asset to use for the next fifteen...

A cash-strapped firm would like to acquire a capital asset to use for the next fifteen years. It can purchase the asset, which costs $50M, by taking out a fifteen-year balloon loan at 5.8% annual interest rate. The firm plans to sell the asset at book value for $15M at the end of the fifteen-year period.

Alternatively, the firm can lease the asset from the manufacturer for $4.75M a year. It is agreed, after negotiating, that the lessor would be responsible for maintaining the asset. Annual maintenance cost for the asset is $500K, in year-end value. The firm uses the straight-line depreciation method and pays a 30% income tax. Should the firm lease or buy the asset?

Please show all work.

Solutions

Expert Solution

Cost of the asset = $ 50 million (which is financed entirely by loan); Annual interest rate = 5.8%; Term = 15 years

Option 1: Taking loan and buying the asset

Yearly interest = 5.8% of $ 50 million = $ 2.9 million

The firm would have an advantage of tax benefit on loan

So, net yearly cash outflow adjusting tax = $ 2.9 million (1-30%) = $ 2.03 million

Total net interest paid in 15 years = $ 2.03 million * 15 years = $ 30,450,000

Loan to be repaid by the firm on its own after 15 years = Loan amount - Salvage value = $ 50 million - $ 15 million = $ 35 million

Therefore, total net outflow in 15 years = $ 30,450,000 + $ 35, 000,000 = $ 65,450,000

Option 2: Leasing of asset

In this option, the firm (lessee) is only concerned about the yearly lease payments as the maintenance costs for the asset will be borne by the lessor

So total cash outflow in 15 years = $ 4.75 million/year * 15 years = $ 71,250,000

The result of both the option shows that the firm should buy the asset.


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