In Class Problem Leasing The X company is considering the acquisition of a new p
ID: 2749404 • Letter: I
Question
In Class Problem Leasing
The X company is considering the acquisition of a new processor that has an estimated installed cost of $57,000. The processor has an expected life of 5 years and will be depreciated over a 5 year ACRS life to a zero salvage value. However, it is expected that the processor can be sold at that time for $6,000. If purchased, the entire $57,000 would be borrowed at an interest rate of 9%. A capital budgeting analysis results in a positive NPV for the project. An alternative to purchase is to lease the asset for an annual lease payment of $13,500. The lease includes maintenance services estimated to cost Company C $3,000 per year if they were not included in the lease payment. Company C’s cost of capital is 11% and its marginal tax rate is 34%. Evaluate the purchase and lease options and make a recommendation of which is preferred.
Explanation / Answer
Alternative -1:-Lease
Present Value of Lease Payments = After Tax Lease Rental*PVIFA(11%,5)
= 13,500*0.66 * PVIFA(11%,5)
= 8,910*3.6959
= $32,930.47
..
..
Alternative-2:-Purchase the New Processor
1
(57000*20%)
= 11,400
=11,400*0.34
= 3,876
=5,130*0.34
= 1,744
(57000*32%)
= 18,240
=18,240*0.34
6,202
=5,130*0.34
= 1,744
(57000*19.20%)
= 10,944
=10,944*0.34
= 3,721
=5,130*0.34
= 1,744
(57,000*11.52%)
= $6,566
=6,566*0.34
= 2,232
=5,130*0.34
= 1,744
(57,000*11.52%)
= $6,566
=6,566*0.34
= 2,232
=5,130*0.34
= 1,744
Present value of Cash outflows from purchase of equipment = (490)/1.11 + (2,816)/1.11^2 + (335)/1.11^3 + 1,154/1.11^4 + 1,154/1.11^5 + 51,924/1.11^5
= -441.44 - 2,285.53 - 271.89 + 760.18 + 684.84 + 30,814.37
= $29,260.53
Note:-
At the end of 5 th year
Additional Cash Outflow = Loan Principal Reapayment
= $57,000
..
Book vale of processor at the end of 5th year = 57,000*5.76%
= $3283
Sale value = $6,000
Profit on Sale = $2717
Tax on Profit = 2717*0.34
= $924
Net Cash Inflow from sale of Processor at the end of 5th year = 6000 - 924
= $5,076
..
..
..
..
..
Since Cash Outflow is least in Purchase Alternative , we should buy the Processor by taking Loan.
Year Interest Depreciation Tax Shiled on Dep Tax sheild on Interest Net Cash Outflow1
5,130(57000*20%)
= 11,400
=11,400*0.34
= 3,876
=5,130*0.34
= 1,744
(490) 2 5,130(57000*32%)
= 18,240
=18,240*0.34
6,202
=5,130*0.34
= 1,744
(2,816) 3 5,130(57000*19.20%)
= 10,944
=10,944*0.34
= 3,721
=5,130*0.34
= 1,744
(335) 4 5,130(57,000*11.52%)
= $6,566
=6,566*0.34
= 2,232
=5,130*0.34
= 1,744
1,154 5 5,130(57,000*11.52%)
= $6,566
=6,566*0.34
= 2,232
=5,130*0.34
= 1,744
1,154 5 Additional Cash outflow (57,000-5076) 51,924