Please show work. Fresh Farming Company is negotiating a lease for five new trac
ID: 2753469 • Letter: P
Question
Please show work.
Fresh Farming Company is negotiating a lease for five new tractors with Leasing International. The terms of the lease offered by Leasing International call for a total payment of $205,000 at the beginning of each year of a 5-year lease.
As an alternative to leasing, Fresh Framing can borrow from a local bank and buy the tractors. Fresh Farming has received its best offer for buying the tractors from Trucks, Inc. for a total price of $1 million. The $1 million would be borrowed on a simple interest term loan at a 10 percent interest rate for 5 years.
The tractors fall into the MACRS 5-year class and have a total expected residual value of $100,000. The depreciation rates are 20.00%, 32.00%, 19.20%, 11.52%, 11.52% and 5.76%. Maintenance costs would be included in the lease payments. If the tractors were owned, a maintenance contract would be purchased at the beginning of each year for $10,000 per year.
In any case, Fresh Farming plans to buy a new fleet of tractors at the end of the fifth year. Leasing International has a 40% federal-plus-state marginal tax rate, while Fresh Farming has a total tax rate of 20%.
a What would be Fresh Farming’s present value of owning the tractors?
b What would be Fresh Farming’s present value of leasing the tractors?
c Should Fresh Farming lease the tractors? Why or why not?
d Assume that the lessor’s alternative to leasing (i.e. making an investment with similar risk to leasing) is to invest in a 5-year certificate of deposit that pays 9 percent before taxes. Show why the lessor write the lease? Why or why not?
Explanation / Answer
a) post tax marginal cost of debt (Kd) = 10%(1-0.20)/100 = 8%
Equated annual loan instalment = 1 million / PVIFA of 9% (5years)
= 1 million / 3.79 = 263852.20
Segregtion of principal and interest amount
Year
Opening balance of loan
Interest paid
Installment paid
Principal paid
1
1000000
100000
263852.2
163852.2
2
836147.8
83614.78
263852.2
180237.4
3
655910.4
65591.04
263852.2
198261.2
4
457649.2
45764.92
263852.2
218087.3
5
239561.9
24290.26
263852.2
239561.9
Salvage value at end of 5 years = 100000
Less- WDV value at end = 344112.5
Capital loss = 244112.5
Less- tax savigs on loss @20% = 48822.5
After tax sale proceeds = 100000 - (-48822.5) = 148822.5
Particulars
Time
PVF
Amount
PV
Payment of installment
1-5
3.99
263852.2
1052770.4
Add- maintenance cost net of tax
1-5
3.99
8000
31920
Less- tax savings on interest amount
1
0.925926
20000
18518.52
2
0.857339
16722.96
14337.24
3
0.793832
13118.21
10413.66
4
0.73503
9152.984
6727.717
5
0.680583
4858.052
3306.309
Less- tax savings on depreciation
1
0.925926
40000
37037.04
2
0.857339
51200
43895.75
3
0.793832
20889.6
16582.84
4
0.73503
10127.28
7443.852
5
0.680583
8960.616
6098.444
Less- terminal value (net of tax)
5
0.680583
148822.5
101286.063
PVCO
819043
b)
Particulars
Amount
PVF (9%)
P.V.
Lease payments
205000
3.89
797450
Less- tax savings on lease payments
41000
3.89
159490
PVCO
637960
C) yes, fresh farming lease the tractors as the present value of cash outflow is less in lease option as compared to buy ooption
Year
Opening balance of loan
Interest paid
Installment paid
Principal paid
1
1000000
100000
263852.2
163852.2
2
836147.8
83614.78
263852.2
180237.4
3
655910.4
65591.04
263852.2
198261.2
4
457649.2
45764.92
263852.2
218087.3
5
239561.9
24290.26
263852.2
239561.9