Happy Cleaners needs a new steam finishing machine that costs $100,000. The comp
ID: 2715780 • Letter: H
Question
Happy Cleaners needs a new steam finishing machine that costs $100,000. The company is evaluating whether it should lease or purchase the machine. The equipment falls into the MACRS 3-year class, and it would be used for 3 years and then sold, because the firm plans to move to a new facility at that time. The estimated value of the equipment after 3 years is $30,000. A maintenance contract on the equipment would cost $3,000 per year, payable at the beginning of each year. Alternatively, the firm could lease the equipment for 3 years for a lease payment of $29,000 per year, payable at the beginning of each year. The lease would include maintenance. The firm is in the 20% tax bracket, and it could obtain a 3-year simple interest loan, interest payable at the end of the year, to purchase the equipment at a before-tax cost of 10%. (Note: MACRS rates for Years 1 to 4 are 0.3333, 0.4445, 0.1481, and 0.0741.)
Question4: Should Happy Cleaners buy or lease the machine?
a. Buy, the net advantage to leasing is $5,734
b. Lease, the net advantage to leasing is $5,734
c. Buy, the net advantage to leasing is $4,822
d. Lease, the net advantage to leasing is $4,822
Explanation / Answer
Cost of the machine =$100,000.
Estimated value of the machine after 3 years=$30,000.
Maintenance contract =$3,000 per year.
Cost of owing the equipment:
After tax cost of interest =10%*(1-0.20)
=8%.
Tax savings on account of depreciation is as follows:
Book value of the machine at the end of year 3 is $7,410 as determined from the above table.
Gain on sale of the machine=$30,000 - Book value of the machine $7,410.
=$22,590.
After tax cash inflow on sale of the machine =$30,000 -$22,590 *20%
=$25,482
Present value of the after tax inflows on sale of machine =$25,482 * 0.735029
=$20,228.43-----------(B)
Present value of maintenance cost =$3,000
cash outflow for maintenance after tax benefit =$3,000 *80%
=$2,400.
Present value of the maintenance cost = $2,400 *Present value annuity factor for 3 years with cash outflow at the beginning of the year
=$2,400 * 2.7832647
=$6,679.84. ----------------(C)
Principal repayment at the end of the 3 years =$100,000
Present value of principal repayment =$100,000*0.79383
=$79,383.22 ----------------(D)
Interest payment at the end of the period net of tax shield =$100000*10%*80%
=$8,000
Present value of interest payments over 3 year period = $8,000 *PVAF $8% for 3 years.
=$8,000 *2,57709
=$20616.78----------(E)
Net tax cash outflow on owing the equipment = D+E+C-B-A
=$70,306.11 rounded to $70,306------------- (X)
Cost of leasing the machine:
Lease payment every year =$29,000
After tax cost of lease =$29,000 *80%
=$23,200.
Present value of the lease payments over 3 years = $23,200 *2.783264746.
=$64,571.7421 rounded to $64,572.--------------(Y)
Benefit of leasing = X-Y =$70,306 -$64,572
=$5,734
Therefore answer is b. Lease, the net advantage to leasing is $5,734.
Year Depreciation rates Depreciation Book value after depreciation Tax savings on account of depreciation Discount factor @8% Present value 0 $100,000.00 1 1 0.3333 $33,330.00 $66,670.00 $6,666.00 0.925925926 $6,172.22 2 0.4445 $44,450.00 $22,220.00 $8,890.00 0.85733882 $7,621.74 3 0.1481 $14,810.00 $7,410.00 $2,962.00 0.793832241 $2,351.33 4 0.0741 0.735029853 Total(A) $16,145.30Related Questions
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