Consider this data : Current Assets $300 Debt $400 Net fixed assets 500 Equity 4
ID: 2663271 • Letter: C
Question
Consider this data :Current Assets $300 Debt $400
Net fixed assets 500 Equity 400
Total assets $800 Total claims $800
Assume the tax rate is 40% and that the equipment depreciation would be $100 per year. If a company leased the asset on a two year lease, the payments would be $110 at the beginning of each year. If the company borrowed and bought the equipment, the bank would charge 10% interest on the loan. Either way, the equipment is worth nothing after two years and will be discarded. Should the company lease or buy the equipment? Why?
Explanation / Answer
The cost of owning or leasing is the present value of cash flows. The discounting rate is the after tax cost of debt. The discounting rate is 10%X(1-0.4) = 6% Cost of Leasing - The payments are $110 per year payable at the beginning. The cash flow is the after tax cost. The after tax cost is 110X(1-0.4) = $66. Since the payments are beginning of the year, 1st payment is now and second is at the beginning of year 2 or end of year 1. The PV is $66 for payment now + 66/1.06 for payment end of year 1 = 66+62 = $128 The total cost is -$128 since it is an outflow. Cost of Owning - Since the depreciation is 100 per year, the cost of the asset is $200. Depreciation will give depreciation tax shield, which is 100X40%=$40 per year at the end of each year. The PV of depreciation tax shield is 40/1.06 + 40/1.06^2 = $73 The outflow is -$200 for purchase and inflow is depreciation benefit is $73 The cost of owning = -200+73 = -$127 company should buy the equipment as the cost is lower.