Question

Jenkins Company has decided to acquire office equipment (copiers, printers, etc.) that it will use at its headquarters building for the next five years. The equipment would cost $500,000 to purchase. Alternately, Jenkins could lease the equipment for five years, at an annual cost of $120,000. The lease includes equipment maintenance, which would otherwise be anticipated to cost $40,000 per year. The estimated salvage value of the equipment after five years is $100,000. The five-year MACRS schedule applies for tax depreciation. Jenkins’ tax rate is 34%. You can assume that, should Jenkins purchase the equipment, it will borrow $500,000 to do so. The loan would call for Jenkins to pay $40,000 per year in interest, and to repay the principal after at the end of year five. The appropriate discount rate for this problem is 5.28% (the after tax cost of borrowing). You can also assume that Jenkins would earn this rate (after tax) on any cash balances. All cash flows except the initial purchase and borrowing are end-of-period. Finally, you can assume that Jenkins’ taxable income is high enough that the tax deductible expenses associated with this decision would indeed reduce the company’s tax liability. (a) Suppose that Jensen wanted to set aside a sum of money now that would be sufficient to fund the after-tax costs of acquiring the assets through the lease. How much money would they need to set aside? (b) Suppose that Jensen wanted to set aside a sum of money now that would be sufficient to fund the after-tax costs of acquiring the assets through the “borrow to purchase” alternative. How much money would they need to set aside? (c) Which alternative do you recommend, and why?

Answer 1

(a) Amount to be set aside to fund the after tax costs of acquiring the assets through lease:
Year	Lease rental	Tax rate	Net expense	PVF	PV of lease
1	120000	0.34	79,200	0.95	75,228
2	120000	0.34	79,200	0.90	71,455
3	120000	0.34	79,200	0.86	67,872
4	120000	0.34	79,200	0.81	64,468
5	120000	0.34	79,200	0.77	61,234
					340,257
	Amount to be set aside is $ 340,527
(b) Amount to be set aside for after-tax costs of acquiring the assets through the “borrow to purchase” alternative.
Year	Interest	Principal	Tax rate	Intt(net of tax	Toal outflow	PVF	PV of Amt required
1	40000	0	34%	26,400	26,400	0.95	25,076
2	40000	0	34%	26,400	26,400	0.90	23,818
3	40000	0	34%	26,400	26,400	0.86	22,624
4	40000	0	34%	26,400	26,400	0.81	21,489
5	40000	500000	34%	26,400	526,400	0.77	406,993
							500,000.00
	Amount to be set aside is $ 500,000
© It is recommended to go for leasing alternative, as that alternative helps Jenkins company to save $ 159,743 (500,000-340,257).