You work for a nuclear research laboratory that is contemplating leasing a diagn

Question

You work for a nuclear research laboratory that is contemplating leasing a diagnostic scanner (leasing is a very common practice with expensive, high-tech equipment). The scanner costs $6,300,000, and it would be depreciated straight-line to zero over four years. Because of radiation contamination, it will actually be completely valueless in four years. You can lease it for $1,875,000 per year for four years.

1. Lease or Buy [LO3] Assume that the tax rate is 35 percent. You can borrow at 8 percent before taxes. Should you lease or buy?

2. Leasing Cash Flows [LO3] What are the cash f ows from the lease from the lessor

Explanation / Answer

1.

Depreciation tax shield = 35%*6300000/4 = $551250

After tax cost of debt = 8%*(1-35%)= 5.2%

After tax lease payment = 1,875,000*(1-35%) =1218750

NPV of leasing is positive and hence you should lease

2.

3. Let maximum lease payment be L

NPV =0 for maximum lease payment

Maximum lease = $1,897,978.36

lease payment for which both lessor and lessee to be indifferent about the lease= $1,897,978.36

4.

0 1 2 3 4 Purchase savings 6300000 Depreciation tax shield lost -551250 -551250 -551250 -551250 Lease payment -1218750 -1218750 -1218750 -1218750 Net cash flow 6300000 -1770000 -1770000 -1770000 -1770000 NPV $52,716.95

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