In: Finance
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.
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.