Reynolds Corporation plans to purchase equipment at a cost of $2 million. The co

Question

Reynolds Corporation plans to purchase equipment at a cost of $2 million. The company's tax-rate is 35 percent and the equipment's depreciation would be $500,000 per year for 4 years. If the company leased the asset on a 4-year lease, the payment would be $600,000 at the beginning of each year. If Reynolds borrowed and bought, the bank would charge 12 percent interest on the loan. a. Calculate the cost of purchasing the equipment. b. Calculate the cost of leasing the equipment. c. Calculate the NAL.

Explanation / Answer

The cost of owning or leasing is the present value of cash flows. The discounting rate is the after tax cost of debt. The discounting rate is 12%X(1-0.35) = 7.8% a. Calculate the cost of purchasing the equipment Depreciation will give depreciation tax shield, which is 500000X35%=$175000 per year at the end of each year The PV of depreciation tax shield is 175000PVIFA(7.8%,4)= $582211.94 cost of purchasing the equipment= 2000000-582211.94= $ 1417788.06 b. Calculate the cost of leasing the equipment The payments are $600000 per year payable at the beginning. The cash flow is the after tax cost. The after tax cost is 600000X(1-0.35) = $390000 PV= 390000+390000 PVIFA(7.8%,3)= $1398705.977 cost of leasing the equipment= $1398705.977 c. NAL= 1417788.06-1398705.977= $19082.08

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