Question

Lease versus Buy Big Sky Mining Company must install $1.5 million of new machinery in its Nevada mine. It can obtain a bank loan for 100% of the purchase price, or it can lease the machinery. Assume that the following facts apply: The machinery falls into the MACRS 3-year class. Under either the lease or the purchase, Big Sky must pay for insurance, property taxes, and maintenance. The firm's tax rate is 40%. The loan would have an interest rate of 15%. It would be nonamortizing, with only interest paid at the end of each year for four years and the principal repaid at Year 4. The lease terms call for $400,000 payments at the end of each of the next 4 years. Big Sky Mining has no use for the machine beyond the expiration of the lease, and the machine has an estimated residual value of $200,000 at the end of the 4th year.

MACRS
Year	Allowance Factor
1	0.3333
2	0.4445
3	0.1481
4	0.0741

What is the NAL of the lease? Round your answer to the nearest dollar.

Answer 1

Cost of the machinery- $15,00,000

Tax rate- 40%

Rate of bank interest- 15%

Lease rental- $400000 per year

Salvage value of machine- $2,00,000

Calculation of depreciation

YEAR Opening balance Depreciation Closing Balance Tax Saving On Depreciation  

1 15,00,000 3,25,000 11,75,000 1,30,000

2 11,75,000 3,25,000 8,50,000 1,30,000  

3 8,50,000 3,25,000 5,25,000 1,30,000

4 5,25,000 3,25,000 2,00,000 1,30,000

Present value of cash outflow under loan option

Year Interest net of tax Principal Repayment Tax saving on depreciation Salvage Value net cash flow PVCO

1 1,35,000 (1,30,000) 5,000 1666.5

2 1,35,000 (1,30,000) 5,000 2222.5

3 1,35,000 (1,30,000) 5,000 740.5

4 1,35,000 15,00,000 (1,30,000) (2,00,000) 13,05,000 96700.5

$101330

Present value of cash outflow under lease option

Year Lease Rental net of tax MACRS Present Value of cash outflow

1 2,40,000 .3333 79,992

2 2,40,000 .4445 1,06,680

3 2,40,000 .1481 35,544

4 2,40,000 .0741 17,784

$2,40,000

NAL= Present Value Of cash outflow for loan- Present Value Of Cash Outflow for Lease

NAL= 1,01,330-2,40,000

NAL= -$1,38,670

Decision- We should take the loan and buy machine