Problem 19-4 Lease versus Buy Big Sky Mining Company must install $1.5 million o
ID: 2729864 • Letter: P
Question
Problem 19-4
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 35%.
The loan would have an interest rate of 16%. (Suppose that only interest payments are made at the end of each year and the whole loan will be paid back at the end of 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 $300,000 at the end of the 4th year.
What is the NAL of the lease? Round your answer to the nearest dollar.
$
MACRS Year Allowance Factor 1 0.3333 2 0.4445 3 0.1481 4 0.0741Explanation / Answer
Calculation of Present Value of Tax Shield on depreciation:
Cost of the machinery = $1.5 million = $15 lacs
Residual Value = $3 lacs
Depreciable Value = $15 lacs - $3 lacs = $12 lacs
Depreciation Schedule:
Year
Calculation
Amount ($)
1
12 * 0.3333
3.9996
2
12 * 0.4445
5.334
3
12 * 0.1481
1.7772
4
12 * 0.0741
0.8892
Calculation of Tax Shelter on Depreciation:
Year
Depreciation
Tax Shield on Depreciation (35%)
PVF (16%)
PV of Tax shield on depreciation
1
3.9996
1.39986
0.862
1.2066
2
5.334
1.8669
0.743
1.3871
3
1.7772
0.62202
0.641
0.3987
4
0.8892
0.31122
0.552
0.1718
3.1642
Calculation of Tax Shield on Interest:
Since loan is repaid at the end of year 4, interest will be same for all the four years.
Interest expense = $15 lacs * 16% = $2.4 lacs
Tax Shield on Interest Expense = $2.4 lacs * 35% = $0.84 lacs
PV of Tax Shield on Interest Expense = $0.84 lacs * PVAF (16%, 4 Years)
= $0.84 lacs * 2.79818
= $2.35 lacs
Present Value of Residual Value:
Present Value of Residual Value = $3 lacs * PVF (16%, 4 Years)
= $3 lacs * 0.5523
= $1.6569 lacs
Present Value of Lease Payments:
Present Value of Lease Payments = $4 lacs * PVAF (16%, 4 Years)
= $4 lacs * 2.79818
= $ 11.19272 lacs
Present Value of Tax Shield on Lease Payments:
Present Value of Tax Shield on Lease Payments = $11.19272 * 35%
= $3.917452 lacs
Net Advantage of Leasing:
Particulars
Amount ($ in lacs)
Cost of asset
15
PV of tax shield on lease rentals
3.917452
Less: PV of tax Shield on depreciation
-3.1642
Less: PV of tax shield on Interest Expense
-2.35
Less: PV of Lease Payments
-11.19272
Less: PV of Residual Value
-1.6569
Net Advantage of Leasing
0.553632
Year
Calculation
Amount ($)
1
12 * 0.3333
3.9996
2
12 * 0.4445
5.334
3
12 * 0.1481
1.7772
4
12 * 0.0741
0.8892