Question

Nick Warf, the company president, has found a vendor for the equipment. Clapton Acoustical Equipment has offered to sell Warf Computers the necessary equipment at a price of $4 million. Because of the rapid development of new technology, the equipment falls in the three-year MACRS depreciation class. At the end of four years, the market value of the equipment is expected to be $480,000.

Alternatively, the company can lease the equipment from Hendrix Leasing. The lease contract calls for four annual payments of $1,040,000, due at the beginning of the year. Additionally, Warf Computers must make a security deposit of $240,000 that will be returned when the lease expires. Warf Computers can issue bonds with a yield of 11 percent, and the company has a marginal tax rate of 35 percent.

1. Calculate the NAL (Net Advantage to Leasing).

Answer 1

A) Buy option

First of all let us calculate depreciation

Year	Opening balance	Depreciation rate	Depreciation	Closing balance
1	4000000	33.33%	1333200	2666800
2	2666800	44.45%	1778000	888800
3	888800	14.81%	592400	296400
4	296400	7.41%	296400	0

Cost of debt = Interest rate(1-tax rate)

=11%(1-0.35)

=11%(0.65)

=7.15%

Statement showing NPV

Particulars	0	1	2	3	4	NPV
Purchase of equipment	-4000000
Depreciation		1333200	1778000	592400	296400
Tax savings @ 35%		466620	622300	207340	103740
Salvage value (480000(1-0.35) =480,000(0.65) =312000					312000
Total Cash flow	-4000000	466620	622300	207340	415740
PVIF @ 7.15%	1	0.9333	0.8710	0.8129	0.7586
PV(Cash flow*PVIF)	-4000000	435482.97	542020.17	168541.39	315393.77	-2538561.70

B) Leasing

Statement showing NPV

Particulars	0	1	2	3	4	NPV
Security deposit	-240000
Lease	-1040000	-1040000	-1040000	-1040000
tax Savings @ 35%	364000	364000	364000	364000
Post tax lease	-676000	-676000	-676000	-676000
Security deposit					240000
Total cash flow	-916000	-676000	-676000	-676000	240000
PVIF @ 7.15%	1.0000	0.9333	0.8710	0.8129	0.7586
PV(Cash flow*PVIF)	-916000	-630891.2739	-588792.6028	-549503.1291	182071.739	-2503115.3

NAL = 2538561.7-2503115.3 = 35446.43