Question

A company wants to get a bullet proof luxurious limousine for its CEO. The limousine would cost $1 million to buy. The limousine will be depreciated at a rate of $100,000 per year for tax purposes. Suppose the limousine could be sold off in five years for $500,000. Suppose also that the firm could alternatively sign a five-year operating lease for the limousine with lease payments of $150,000 per year. Each payment would be due at the beginning of the year. The company’s effective tax rate is 25 percent. The before –tax rate of borrowing is 8 percent. Cash Flows in $ Year 0 1 2 3 4 5 Initial Cost After tax lease payment Forgone tax shield Forgone salvage value Column Total (b). Determine Net Present Value of Leasing assuming payments are made annually and make a lease or buy decision.

Answer 1

Given that company depreciating limousine at 100000

Tax on depreciation is 100000×25%=25000

Discounted value for year 1at 8% =25000×0.9259=23147.5

Discounted value for year 2 =25000×0.8573=21432.5

Discounted value for year 3=25000×0.7938=19845

Discounted value for year 4=25000×0.7350=18375

Discounted value for year 5=2500×0.6806=17015

Discounted value for salvage value at year 5=500000×0.6806=340300

Total discounted value =440115

NVP=1000000-440115=559885

If company gonna with lease

Lease agreement given is 150000

Tax savings on lease is 150000×25%=37500

Net cash out flow is 150000-37500=112500

Discounted cash flow for year 1at 8%=112500×0.9259=104163.75

Discounted cash flow for year 2 =112500×0.8573=96446.25

Discounted cash flow for year 3=112500×0.7938=89302.5

Discounted cash flow for year 4=112500×0.7350=82687.5

Discounted cash flow for year 5=112500×0.6806=76567.5

Total=449167.5

Cash out flow with leasing is low so company should go with leasiios better option