Problem 19-4 Lease versus Buy Big Sky Mining Company must install $1.5 million o
ID: 2730113 • 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: 1.The machinery falls into the MACRS 3-year class. 2.Under either the lease or the purchase, Big Sky must pay for insurance, property taxes, and maintenance. 3.The firm's tax rate is 35%. 4.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.) 5.The lease terms call for $400,000 payments at the end of each of the next 4 years. 6.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. MACRS Year Allowance Factor 1 0.3333 2 0.4445 3 0.1481 4 0.0741 What is the NAL of the lease? Round your answer to the nearest dollar.Explanation / Answer
Answer:
NAL = Cash outflow from bank loan option - cash outflow from lease option
(A) Cash outflow under lease option = lease payment (1-tax rate) x present value factor @16%, for 4 years
= 400,000 (1-0.35) x 2.7981
= 727,506
Note: it is assumed that loan interest rate is discount rate
(B) cash outflow under bank loan option
So, Net advantage of lease = Cash outflow from bank loan option - cash outflow from lease option
= 18,33,898 - 727,506
= 11,06,392
Note: Maintenace, insurance and tax was ignored because those expenses are same under both the options
Year loan interest and principal repayment (A) Depreciation as per MACRS (B) Tax saving due to loan intererest payment C =(A+B)*35% cash outflow after considering tax saving D = (A - C) Present value factor @ 16% = E Present value of cash outflow = (D x E) 1 (15,00,000 x 16%) = 240,000 4,99,950 2,58,982.50 4,80,967.50 0.8620 4,14,627.20 2 240,000 6,66,750 3,17,362.50 5,89,387.50 0.7431 4,38,010.90 3 240,000 2,22,150 1,61,752.50 3,00,397.50 0.6406 1,92,452.00 4 240,000 1,11,150 1,22,902.50 2,28,247.50 0.5522 1,26,059.10 4 12,00,000 = total cash out flow =(principal amount repayment - residual value received for machinery) - - - 0.5522 6,62,749.30 Total cash outflow from loan option 18,33,898