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 $5,200,000, and it would be depreciated straight-line to zero over three years. Because of radiation contamination, it will actually be completely valueless in three years. You can lease it for $2,225,000 per year for three years. Assume that the tax rate is 35 percent. You can borrow at 14 percent before taxes. Calculate the NAL. (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16)) NAL $ Should you lease or buy? Lease Buy

Explanation / Answer

Option 1 -

If Nuclear research laboratory decides to buy the diagnostic scanner for $ 5200000 assuming they take full amount as loan @ 14%

Cost of asset - $ 52,00,000

Depreciation cost year 1 $ 17,33,333.33 (a)

Interest cost year 1 $ 7,28,000 (b)

Total Expense $ 2,461,333.33 (a) + (b)

Tax benefit on expense@35% $ 861,466.67

Option 2 If the laboratory decides to lease the scanner

Lease value $ 2225000

Tax benefit on lease value @ 35% $ 778,750

From above it can derived that option 1 that is buying the asset is more beneficial because the laboratory can get more tax benefit ($ 861466.67 - $ 778750) of $ 82716.67 in year 1 and accordingly the benefit would be comparatively higher in balance part of year as well.

Assumption - In above I have assumed that the laboratory would finance the entire value of $ 52,00,000 through loan.

Note - Calculation is limited only for year 1 as the laboratory would be paying some value towards the principal amount of loan at the end of year 1 and accordingly the interest amount would fall to that extent in year 2 and year 3 and that value of repayment is unavailable in question.

But overall cummulative benefit would be more under option 1 that under 2 of leasing owing to tax benefit on interest expense.

So the company should buy.

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