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Angie Corporation is evaluating whether to lease or purchase equipment. Its tax rate is 30 percent.  If...

Angie Corporation is evaluating whether to lease or purchase equipment. Its tax rate is 30 percent.  If the company purchases the equipment for $2,000,000 it will depreciate it over 4 years, using straight-line depreciation. No salvage value is expected.  If the company enters into a 4-year lease, the lease payment is $600,000 per year, payable at the beginning of each year. If the company purchases the equipment it will borrow from its bank at an interest rate of 10 percent.  

Calculate the cost of purchasing the equipment.

Solutions

Expert Solution

Purchase
Interest rate 10%
Tax 30%
Effective rate 7.00%
Year 0 1 2 3 4
Depreciation 500000 500000 500000 500000
Tax shield 150000 150000 150000 150000
Interest payment 200000 200000 200000 200000
Tax shield 60000 60000 60000 60000
Total tax shield 210000 210000 210000 210000
Less: interest payment 200000 200000 200000 200000
Less: loan repayment 2000000
Net cash Flow 10000 10000 10000 -1990000
NPV @ 7% ($1,491,918.31)
So cost of purchase $1,491,918.31
Lease
Year 0 1 2 3 4
Lease payment 600000 600000 600000 600000
Tax shield 180000 180000 180000 180000
Net cash out Flow 420000 420000 420000 420000 0
NPV @ 7% ($682,212.74)
So cost of lease $682,212.74
Clearly leasing is cheaper

jeff jeffy answered 7 months ago
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