Question

The Barnstormer Corp. needs new equipment that would cost $3.5 million and would fall into the MACRS 5-year class for depreciation purposes. Maintenance would be $160,000 per year, payable at the beginning of each year, if they buy the equipment themselves. They could borrow at a 9% rate of interest, before tax, if they were to buy the equipment directly. They plan on using the equipment for 5 years before it will need to be replaced with something more modern. The estimated residual value of the equipment in five years is $750,000.

Barnstormer has found a leasing company that would be willing to lease the equipment to them for 5 years for $570,000 per year, payable at the beginning of the year. Maintenance would be included in the lease payment. Barnstormer is in the 30% marginal tax bracket.

1. Should Barnstormer lease the equipment or buy the equipment? Explain.

2. What is the NPV of the lease to the leasing company if they have a borrowing rate of 6% and a tax rate of 45%

Answer 1

1)

a) Below table shows the tax benefit every year from depreciation and interest if we purchase the equipment:

Year	Depreciation rate using MACRS	Depreciation amount	Interest payment	Total Depr. + Interest	Tax benefit
1	20%	700,000	315,000	1,015,000	304,500
2	32%	1,120,000	315,000	1,435,000	430,500
3	19.20%	672,000	315,000	987,000	296,100
4	11.52%	403,200	315,000	718,200	215,460
5	11.52%	403,200	315,000	718,200	215,460

b) If we purchase the equipment payment in every year would be Interest plus annual maintenance minus the tax benefit from interest and depreciation. Additional $3.5m equipment cost outflow in the first year and $750,000 inflow from residual value in 5th year.

c) if we lease the equipment then annual payment would be lease expenses multiplied by 0.70 to adjust for the tax benefit from lease expenses.

Below table shows the NPV in both cases:

Year	Payment if purchase equipment	Present value if purchase the equipment	Payment if leases equipment	Present value if leases equipment
1	-3,355,500	-3,078,440	-399,000	-366,055
2	-44,500	-37,455	-399,000	-335,830
3	-178,900	-138,144	-399,000	-308,101
4	-259,540	-183,865	-399,000	-282,662
5	490,460	318,765	-399,000	-259,323
NPV		-3,119,138		-1,551,971

NPV if we leases the equipment is higher than the NPV if we purchase it. Hence company should lease the equipment.

2) NPV to leasing company assuming discounting interest rate is 6% and tax rate of 45%

Year	Payment received on lease (adj. for tax)	Present value
1	313500	295,755
2	313500	279,014
3	313500	263,221
4	313500	248,321
5	313500	234,265
NPV		1,320,576