Carolina Inc. is deciding whether to buy or lease a piece of equipment. Analyst
ID: 2803043 • Letter: C
Question
Carolina Inc. is deciding whether to buy or lease a piece of equipment. Analyst estimated the CFs associated with both options. Equipment can be purchased for $100,000, it will last for 10 years and will be depreciated straight line to zero (no residual value). Alternatively, Carolina can lease this equipment at $14,000 per year. Since this is true tax lease, Carolina can deduct lease payments as an operating expense when they are paid. If Carolina’s borrowing rate is 7% and tax rate is 40%, should Carolina lease or purchase equipment? Why? (Hint: depreciation creates tax shield, lease payments also create tax shield).
Explanation / Answer
We can calculate the net present value of each option to decide whether to buy or lease the equipment. Yearly cash outflow associated with lease option = Lease payment - Tax shield = $14000 - [$14000*40%] = $8,400 Yearly cash inflow associated with buy option = Tax shield due to depreciation = $10000 * 40% = $4000 Calculation of net present value Year Discount Factor @ 7% Lease Option Buy Option Cash flow Present Value Cash flow Present Value 0 1 $0.00 $0.00 -$100,000.00 -$100,000.00 1 0.934579 -$8,400.00 -$7,850.47 $4,000.00 $3,738.32 2 0.873439 -$8,400.00 -$7,336.89 $4,000.00 $3,493.75 3 0.816298 -$8,400.00 -$6,856.90 $4,000.00 $3,265.19 4 0.762895 -$8,400.00 -$6,408.32 $4,000.00 $3,051.58 5 0.712986 -$8,400.00 -$5,989.08 $4,000.00 $2,851.94 6 0.666342 -$8,400.00 -$5,597.27 $4,000.00 $2,665.37 7 0.62275 -$8,400.00 -$5,231.10 $4,000.00 $2,491.00 8 0.582009 -$8,400.00 -$4,888.88 $4,000.00 $2,328.04 9 0.543934 -$8,400.00 -$4,569.04 $4,000.00 $2,175.73 10 0.508349 -$8,400.00 -$4,270.13 $4,000.00 $2,033.40 NPV -$58,998.08 -$71,905.67 As the present value of cash outflow is more in case of buy option , Carolina should lease the equipment.