Suppose a company wants to decide whether to lease or purchase an asset. Purchas

Question

Suppose a company wants to decide whether to lease or purchase an asset. Purchase: The capital cost required to purchase the asset is $1,000,000 (at time zero) with a salvage value of $500,000 at the end of the 5th year. The purchased asset can be depreciated based on MACRS 5-year life depreciation with the half year convention (table A-1 at IRS) over six years (from year 0 to year 5). Lease: The asset can be leased for 5 years and annual lease payments (LP) of $250,000 (from year 1 to year 5). The asset would yield the annual revenue of $350,000 for five years (from year 1 to year 5) and operating cost of $60,000 for year 1 to 5. Considering income tax of 35% and minimum ROR of 8%, calculate the ATCF and NPV for both alternative and conclude which alternative is a better decision

Explanation / Answer

Ans-

Calculation of depreciation with half year conversion =1000000-500000/5

                                                                                   =100000/2

                                                                                   =$50000

So purchase option is better.

NPV Under Purchase Option Annual Revenue Opreating Cost Depreciation EBT tax @35% EAT EAT + Dep DF @8% PV 350000 60000 50000 240000 84000 156000 206000 0.926 190756 350000 60000 50000 240000 84000 156000 206000 0.857 176542 350000 60000 50000 240000 84000 156000 206000 0.794 163564 350000 60000 50000 240000 84000 156000 206000 0.735 151410 350000 60000 50000 240000 84000 156000 206000 0.681 140286 Net Cash flow 822558 Add-Salvage Value(500000*0.681) 340500 Less-Investment -1000000 NPV         $ 163058

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