Question

Sadik Industries must install $1 million of new machinery in its Texas plant. It can obtain a bank loan for 100% of the required amount. Alternatively, a Texas investment banking firm that represents a group of investors believes that it can arrange for a lease financing plan. Assume that these facts apply:

1.The equipment falls in the MACRS 3-year class.
2. Estimated maintenance expenses are $46,000 per year.
3.The firm's tax rate is 30%.
4.If the money is borrowed, the bank loan will be at a rate of 13%, amortized in six equal installments at the end of each year.
5.The tentative lease terms call for payments of $280,000 at the end of each year for 3 years. The lease is a guideline lease.
6.Under the proposed lease terms, the lessee must pay for insurance, property taxes, and maintenance.
7.Sadik must use the equipment if it is to continue in business, so it will almost certainly want to acquire the property at the end of the lease. If it does, then under the lease terms it can purchase the machinery at its fair market value at Year 3. The best estimate of this market value is $230,000, but it could be much higher or lower under certain circumstances. If purchased at Year 3, the used equipment would fall into the MACRS 3-year class. Sadik would actually be able to make the purchase on the last day of the year (i.e., slightly before Year 3), so Sadik would get to take the first depreciation expense at Year 3 (the remaining depreciation expenses would be at Year 4 through Year 6). On the time line, Sadik would show the cost of the used equipment at Year 3 and its depreciation expenses starting at Year 3.

Year 3-year MACRS
1) 33.33 %
2) 44.45 %
3) 14.81 %
4) 7.41 %

What is the net advantage of leasing? Do not round intermediate calculations. Round your answer to the nearest dollar.

Answer 1

	OPTION -1- BUY THE EQUIPMENT- 100% FINANCE
	PARTICULARS	Y1	Y2	Y3	Y4	Y5	Y6
A	PRINCIPLE REPAYMENT	120153	135773	153424	173369	195907	221375	1000000
B	INTEREST ELEMENT NET OF TAX	91000	80066	67711	53749	37973	20145	350644
C	MAINTENANCE COST- NET OF TAX = 46000 X 0.7	32200	32200	32200	32200	32200	32200	193200
D	SAVING OF TAX ON DEPRECIATION	99990	133350	44430	22230			300000
		(1000000*33.33%)*30%	(1000000*44.45%)*30%	(1000000*14.81%)*30%	(1000000*7.41%)*30%
	NET OUTFLOW OF FUNDS IN BUY OPTION = A+B+C-D	143363	114689	208904	237088	266079	273720	1243844
	Present value factor @ 13% ( As outflows are unequal in both options )	0.88	0.78	0.69	0.61	0.54	0.48
	Present Values of outflows	126870	89818	144781	145410	144417	131473	782770
	OPTION-2- LEASING
	PARTICULARS	Y1	Y2	Y3	Y4	Y5	Y6
A	LEASE RENTALS- NET OF TAX = 280000 X 70%	196000	196000	196000
B	COST OF EQUIPMENT			230000
C	SAVING OF TAX ON DEPRECIATION			22998	30671	10219	5113
				(230000*33.33%)*30%	(230000*44.45%)*30%	(230000*14.81%)*30%	(230000*7.41%)*30%
	NET OUTFLOW OF FUNDS IN LEASE OPTION = A+B-C	196000	196000	403002	-30671	-10219	-5113	749000
	Present value factor @ 13% ( As outflows are unequal in both options )	0.88	0.78	0.69	0.61	0.54	0.48
	Present Values of outflows	173451	153497	279301	-18811	-5546	-2456	579436
	NET advantage of leasing AT PRESENT VALUES	782770	MINUS	579436	203334
	working notes
we assume that loan repayed in equal installment including interest, but in other hand we can assume that loan may repaid as $ 200000 + interest
if we assume repayments as $ 200000 + interest, then only table will require, no need of Formula
ANNUAL EQUAL INSTALLMET = [P x R x (1+R)^N]/[(1+R)^N-1]
	P	1000000
	R	0.13
	N	6
	(1+R)^N	2.08
	[(1+R)^N-1]	1.08
						156
	[P x R x (1+R)^N]/[(1+R)^N-1]	250153
	Loan repayment schedule	1000000
Sl.	1	2	3	4	5	6	TOTAL	NET OF TAX
Interest	130000	114380	96730	76784	54247	28779	500919	350644
Principal	120153	135773	153424	173369	195907	221375	1000000
Balance	879847	744074	590650	417281	221375	0
six equal installment	250153	250153	250153	250153	250153	250153