Company B needs a new steam finishing machine that costs $100,000. The company i
ID: 2452258 • Letter: C
Question
Company B needs a new steam finishing machine that costs $100,000. The company is evaluating whether it should lease or purchase the machine. The equipment falls into the MACRS 3-year class, and it would be used for 3 years and then sold, because the firm plans to move to a new facility at that time. The estimated value of the equipment after 3 years is $30,000. A maintenance contract on the equipment would cost $3,000 per year, payable at the beginning of each year. Alternatively, the firm could lease the equipment for 3 years for a lease payment of $29,000 per year, payable at the beginning of each year. The lease would include maintenance. The firm is in the 20% tax bracket, and it could obtain a 3-year simple interest loan, interest payable at the end of the year, to purchase the equipment at a before-tax cost of 10%. (Note: MACRS rates for Years 1 to 4 are 0.3333, 0.4445, 0.1481, and 0.0741.) What is the principal repayment in Year 2?
a. $33,233
b. $0
c. $6,979
d. $10,000
What is the after-tax interest payment in Year 3?
a. $8,000
b. $2,924
c. $3,656
d. $6,000
How much is the after-tax salvage value at the end of Year 3 if Company B buys the machine?
a.
$20,964
b.
$24,000
c.
$30,000
d.
$25,482
Should Company B buy or lease the machine?
a.
Buy, the net advantage to leasing is $5,734
b.
Lease, the net advantage to leasing is $5,734
c.
Buy, the net advantage to leasing is $4,822
d.
Lease, the net advantage to leasing is $4,822
a.
$20,964
b.
$24,000
c.
$30,000
d.
$25,482
Explanation / Answer
Alternate 1- Lease Option-
Annual Lease Rental=29000
Lease Term= 3 year
Cost of Debt(After tax)=10%*(1-.20)=8%
Calculation of PV of OUTFLOE
Year
0
1
2
3
Annual Lease Rent
29000
29000
29000
Tax Saving on Lease Rent @20%
5800
5800
5800
Net Outflow
29000
23200
23200
-5800
PVF @ 8%
1
0.926
0.857
0.794
Present Value of Outflow
29000
21481.48148
19882.4
-4605.2
Total Outflow under lease option
65758.68
Alternate 2. Purchase option- Take a Loan from Bank @10% and buy machine.
Cost of machine=100000
Maintainance=3000 p.a. payble at begning of each year
Salvage at end of 3 year=30000
Calculation of Depreciation and tax saving-
Year
MACRS
Cost
Dep.
Tax Saving on Dep
1
0.3333
100000
33330
6666
2
0.4445
100000
44450
8890
3
0.1481
100000
14810
2962
92590
18518
Book Value at end of year 3=100000-92590=7410
Profit on sale of machine=30000-7410=22590
Capital gain tax=22590*.2=4518(assume 20% cap gain tax)
Net inflow from sale=30000-4518=25482
Note. It has been assumed that Principal amount of loan will be paid at end of year 3 because it not mentioned in ques.
Year
Prin. o/s
Interest
Instalment
1
100000
10000
10000
2
100000
10000
10000
3
100000
10000
110000
Tax Saving on Interest=10000*.20=2000p.a.
Calculation of PV of Outflow
Year
0
1
2
3
Interest payment
0
10000
10000
10000
Iprincipal Payment
0
0
100000
Tax Saving on Interest
($2,000)
($2,000)
($2,000)
Tax Saving on Dep
0
($6,666)
($8,890)
($2,962)
Annual Maintainance
3000
3000
3000
$0
Sale of Machine
$25,482
Tax Saving on Maintan.
($600)
($600)
($600)
Net Outflow
3000
3734
1510
129920
PVF @ 8%
1
0.926
0.857
0.794
Present Value of Outflow
3000
3457.41
1294.07
103156.48
Total PV of Outflow
110907.96
Conclusion- PV of outflow under 2nd option 110907.96 is more than outflow under option 1st 65758.68, hence company should take assets on lease.because PV outflow is less than purchase option.
Year
0
1
2
3
Annual Lease Rent
29000
29000
29000
Tax Saving on Lease Rent @20%
5800
5800
5800
Net Outflow
29000
23200
23200
-5800
PVF @ 8%
1
0.926
0.857
0.794
Present Value of Outflow
29000
21481.48148
19882.4
-4605.2
Total Outflow under lease option
65758.68
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