I need help with this question, answer A. 5% is not correct. AHS must install a
ID: 2785845 • Letter: I
Question
I need help with this question, answer A. 5% is not correct.
AHS must install a new $1.5 million computer to track patient records in its multiple service areas. It plans to use the computer for only 3 years, at that time a new system will be acquired that will handle both billing and patient records. The company can borrow money at a before-tax cost of 10%. In lieu of buying, AHS could lease the computer for 3 years. Assume that the following facts apply: The computer falls into the 3-year class for tax depreciation, so the modified accelerated cost recovery system (MACRS) allowances are 0.33, 0.45, 0.15, and 0.07 in Year 1 through Year 4, respectively. The company's marginal tax rate is 34%. Tentative lease terms call for payments of $500,000 at the beginning of each year. The best estimate for the value of the computer after 4 years of wear and tear is $300,000.
What is the internal rate of return (IRR) of the lease?
A. 5% not the correct answer
B. 7%
C. 19%
D. 29%
Explanation / Answer
Depreciation tax savings Year Depreciation Rate Depreciation = 1.5 million x rates Depreciation tax savings 1 33.00% 495000 168300 2 45.00% 675000 229500 3 15.00% 225000 76500 4 7.00% 105000 35700 Tax on residual value = $300,000 - ($1,500,000 - 495000-675000-225000)x34% $66,300 Cost of owning Year Depreciation tax savings Residual value Tax on residual Net cash flow 1 $168,300 $168,300 2 $229,500 $229,500 3 $76,500 $300,000 -$66,300 $310,200 Cost of Leasing Year Lease payment Tax savings from lease Net cash flow 1 $500,000 -$170,000 $330,000 2 $500,000 -$170,000 $330,000 3 $500,000 -$170,000 $330,000 Internal rate of return of the lease: Year 0 1 2 3 Cost of Leasing $0 -$330,000 -$330,000 -$330,000 Cost of owning -$1,500,000 $168,300 $229,500 $310,200 NAL $1,500,000 -$498,300 -$559,500 -$640,200 IRR 6.19% Option b = 7% is correct