Alamo Annuities Inc. has decided to acquire a new quotation system for its San A

Question

Alamo Annuities Inc. has decided to acquire a new quotation system for its San Antonio office. The system receives current market prices and other information from several on-line data services, then either displays the information on a screen or stores it for later retrieval by the firm’s brokers. The system also permits customers to call up current quotes on terminals in the lobby. The equipment costs $2,000,000, and, if it were purchased, Alamo could obtain a term loan for five years for the full purchase price at a 12 percent interest rate. The loan would be interest only each year and the full principal payment at the end of year five. The equipment has a seven-year useful life and it can be depreciated on a straight-line basis. If the system were purchased, a 5-year maintenance contract could be obtained at a cost of $40,000 per year, payable at the beginning of each year. The equipment would be sold after 5 years, and the best estimate of its residual value at that time is $350,000. However, since real-time display system technology is changing rapidly, the actual residual value is uncertain. As an alternative to the borrow-and-buy plan, the equipment manufacturer informed Alamo that Houston Leasing would be willing to write a 5-year guideline lease on the equipment, including maintenance, for payments of $500,000 at the beginning of each year. Lewis’s marginal federal-plus-state tax rate is 33 percent. You have been asked to analyze the lease-versus-purchase decision. Compute the NAL for this transaction. Should Alamo lease or borrow and buy? Comment on the effects that a different loan rate and residual value would have on your answer above.

Explanation / Answer

Solution.

Calculation of NAL:

Cost of Asset

- PV of Lease rentals

+ PV of tax shield on lease rentals

- PV of interest on debt tax shield

- PV of tax shield on depreciation

- PV of salvage value

+ PV of maintenance costs after tax

Pre Tax Rate = 12%

Post Tax Rate = 12%(1-0.33) = 8.04%

(A) P.V. of Lease Rentals

Lease Rentals = $500000 payable at beginning of each year.

PV of Lease Rentals = [PVFIA (8.04%, 4 years) + 1] * $500000

= 4.309 * $500000 = $2154500

(B) P.V. of Tax Shield

Tax saved = Tax Rate * Amount

= 0.33 * $500000 = $165000 per year

PV = PVFIA (8.04%, 5 years) * $165000

= 3.99 * $165000 = $658350

(C) P.V. of Depreciation Tax Shield

Depreciation per annum= ($2000000-$350000) / 5 = $330000

Tax shield = $330000 * 0.33 = $108900

PV of Tax Shield = PVFIA (8.04%, 5 years) * $108900

= 3.99 * $108900 = $434510

(D) P.V. of Interest Tax Shield

Interest per annum = $2000000 * 12% = $240000

Tax shield = $240000 * 0.33 = $79200

PV of Tax Shield = PVFIA (8.04%, 5 years) * $79200

= 3.99 * $79200 = $26136

(E) P.V. of Salvage

P.V. of Salvage = $350000 * PVF (8.04%, 5)

= $350000 * 0.679 = $237650

(F) PV of maintenance costs after tax

Maintenance costs after tax = $40000 (1-0.33) = $26800

PV = [PVFIA (8.04%, 4 years) + 1] * $26800

= 4.309 * $26800 = $115481

NAL = $2000000 - $2154500 + $658350 - $434510 - $26136 - $237650 + $115481

= -$78965

Since NAL is negative borrow and buy option is more advisable then leasing.

* The borrow and buy decision would become less lucrative with increase in interest rate.

* The borrow and buy decision would become be more approachable with increase in residual value.

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