Riverton Mining plans to purchase or lease $190,000 worth of excavation equipmen

Question

Riverton Mining plans to purchase or lease

$190,000

worth of excavation equipment. If? purchased, the equipment will be depreciated on a? straight-line basis over five?years, after which it will be worthless. If? leased, the annual lease payments will be

$44,007

per year for five years. Assume? Riverton's borrowing cost is

8.5%?,

its tax rate is

40%?,

and the lease qualifies as a true tax lease.

a. If Riverton purchases the? equipment, what is the amount of the? lease-equivalent loan?

b. Is Riverton better off leasing the equipment or financing the purchase using the? lease-equivalent loan?

c. What is the effective? after-tax lease borrowing? rate? How does this compare to? Riverton's actual? after-tax borrowing? rate?

Explanation / Answer

Riverton Mining Excavation Equipment 190000 Useful life 5 Years Straight line Depreciation=($190000/5) 38000 Annual Lease Payment for 5 years 44007 Per Year Borrowing Cost 8.5% Tax Rate 40% Tax shield of Depreciation(38000*40%) 15200 Net of Tax lease payment=($44007)*(1-40%) 26404.2 B c D E F (A) (B) (A)-(B) IRR Year Leasing Buying Free cash of leasing compared to buying 0 $     -26,404.20 $ -1,90,000.00 $    1,63,595.80 1 $     -26,404.20 $       15,200.00 $      -41,604.20 2 $     -26,404.20 $       15,200.00 $      -41,604.20 3 $     -26,404.20 $       15,200.00 $      -41,604.20 4 $     -26,404.20 $       15,200.00 $      -41,604.20 5 $       15,200.00 $      -15,200.00 IRR(E15:E20) 4% Riverton's after tax cost of debt=8.5%*(1-.40) 5.10% Loan Amount=(-41604.20/1.051)^1+(-41604.20/(1.051)^2+-41604.20/(1.051)^3+(-41604.20/(1.051)^4+(-15200/(1.051)^5) $ -1,59,037.43 If Riverton leases it pays $26404.20 after tax as an initial lease payment.If it buys using the lease equivalent loan, it pays $190000-$159037.43=30962.57 immediately.Buying with the lease equivalent is expensive by $30962.57-$26404.20=$4558.37 It is better to lease IRR 4% is lesser than after tax cost of debt i.e 8.5%*(1-.40)=5.10% so lease is attractive.

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