To finance some manufacturing tools it needs for the next 3 years, Waldrop Corpo
ID: 2645323 • Letter: T
Question
To finance some manufacturing tools it needs for the next 3 years, Waldrop Corporation is considering a leasing arrangement. The tools will be obsolete and worthless after 3 years. The firm will depreciate the cost of the tools on a straight-line basis over their 3-year life. It can borrow $4,800,000, the purchase price, at 10% and buy the tools, or it can make 3 equal end-of-year lease payments of $2,100,000 each and lease them. The loan obtained from the bank is a 3-year simple interest loan, with interest paid at the end of each year (note: simple interest means that the borrower pays only interest during the life of the loan and repays the principal at maturity, just like a bond). The firm's tax rate is 40%. Annual maintenance costs associated with ownership are estimated at $240,000, but this cost would be borne by the lessor if it leases. What is the net advantage to leasing (NAL), in thousands? (Suggestion: Delete 3 zeros from dollars and work in thousands.) Please show work.
a. $96
b. $106
c. $112
d. $117
e. $123
Explanation / Answer
SOLUTION:
Step 1:
Calculating expenditure if tools are purchased: amount (000)
Particulars
1st year
2nd year
3rd year
Browed amount for purchase (a)
0
0
4800
Interest on loan amount (b)
(480)
(480)
(480)
Tax saving on interest b*(1-40%)= (c)
(288)
(288)
(288)
Depreciation (d)
1600
1600
1600
Tax saving on depreciation d*(1-40%)= (e)
640
640
640
Maintenance cost (f)
(240)
(240)
(240)
Tax saving on maintenance cost f*40%=(g)
960
960
960
Cash flow net (h)=(a+c+e+f+g)
208
208
4592
Pv cost if purchased of assets
3474
Notes:
Depreciation on straight line basis so =4800/3=1600
Amount of depreciation = 1600
Interest on borrowed amount = 4800*10/100=480
Amount of interest = 480
Step 2;
Calculating expenditure if tools are leased: amount (000)
Lease payment (m)
(2100)
(2100)
(2100)
Tax saving on amount m*40%=(n)
840
840
840
net cash flow
(1260)
(1260)
(1260)
Pv if tools are leased
(3367)
Step 3 :
Comparing of PV of purchasing and leasing amount
PV of cost of purchasing = [208/(1+6%)]+[208/(1+6%)^2]-[4592/(1+6%)^3]
PV of cost of purchasing = 3474
PV for cost of leasing = 1260*[1/(1+6%)+1/(1+6%)^2+1/(1+6%)^3]
PV for cost of leasing = 3367
Step 4:
NAL = PV cost of purchasing – PV of leasing
= 3474 – 3367
NAL = 106.2
Particulars
1st year
2nd year
3rd year
Browed amount for purchase (a)
0
0
4800
Interest on loan amount (b)
(480)
(480)
(480)
Tax saving on interest b*(1-40%)= (c)
(288)
(288)
(288)
Depreciation (d)
1600
1600
1600
Tax saving on depreciation d*(1-40%)= (e)
640
640
640
Maintenance cost (f)
(240)
(240)
(240)
Tax saving on maintenance cost f*40%=(g)
960
960
960
Cash flow net (h)=(a+c+e+f+g)
208
208
4592
Pv cost if purchased of assets
3474
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