Question

To finance some manufacturing tools it needs for the next 3 years, Waldrop Corporation is considering a leasing arrangement. The tools will be obsolete and worthless after 3 years. The firm will depreciate the cost of the tools on a straight-line basis over their 3-year life. It can borrow $4,800,000, the purchase price, at 10% and buy the tools, or it can make 3 equal end-of-year lease payments of $2,100,000 each and lease them. The loan obtained from the bank is a 3-year simple interest loan, with interest paid at the end of the year. The firm's tax rate is 25%. Annual maintenance costs associated with ownership are estimated at $240,000, but this cost would be borne by the lessor if it leases. What is the net advantage to leasing (NAL), in thousands? (Suggestion: Delete 3 zeros from dollars and work in thousands.)

a. $119

b. $139

c. $132

d. $146

e. $153

Answer 1

Cost of owing equipment
	Year 1	Year 2	Year 3	Total
Interest	$            -4,80,000	$            -4,80,000	$            -4,80,000
Maintenance	$            -2,40,000	$            -2,40,000	$            -2,40,000
Depreciation (4800000/3)	$          -16,00,000	$          -16,00,000	$          -16,00,000
Total	$          -23,20,000	$          -23,20,000	$          -23,20,000
Tax saving at 25%	$              5,80,000	$              5,80,000	$              5,80,000
Income After Tax	$          -17,40,000	$          -17,40,000	$          -17,40,000
Add: depreciation	$           16,00,000	$           16,00,000	$           16,00,000
Cash flow after tax	$            -1,40,000	$            -1,40,000	$            -1,40,000
Loan repayment			$          -48,00,000
PV factor at 7.5%	0.9302	0.8653	0.8050
PV of Cash Flow	$            -1,30,233	$            -1,21,147	$          -39,76,505	$         -42,27,884
Cost of leasing
	Year 1	Year 2	Year 3	Total
Lease payment	$          -21,00,000	$          -21,00,000	$          -21,00,000
Tax Saving On Lease @25%	$              5,25,000	$              5,25,000	$              5,25,000
Net Cost	$          -15,75,000	$          -15,75,000	$          -15,75,000
PV factor at 7.5%	0.9302	0.8653	0.8050
PV of Lease Costs	$          -14,65,116	$          -13,62,899	$          -12,67,813	$         -40,95,828
Therefore NAL = 4227884-4095828
=$132056
= $1320 ( in thousands)
Correct Option : c