Reynolds Corporation plans to purchase equipment at a cost of $3 million. The co
ID: 2716597 • Letter: R
Question
Reynolds Corporation plans to purchase equipment at a cost of $3 million. The company's tax-rate is 30 percent and the equipment's depreciation would be $600,000 per year for 5 years. If the company leased the asset on a 5-year lease, the payment would be $700,000 at the beginning of each year. If Reynolds borrowed and bought, the bank would charge 11 percent interest on the loan. a. Calculate the cost of purchasing the equipment with debt. b. Calculate the cost of leasing the equipment. c. Calculate NAL? Should the company buy or lease the equipment? Why?
Explanation / Answer
Reynolds Corporation Cost of capital taken= 11% Tax rate 30% Results may differ due to discount factor used, I am using 4 digit discount factor for accuracy a. Buying Cost Purchase cost Interest Cost @11% Post Tax Cost Of Interest Depreciation Tax shield @30% saving Net Cost of Purchase Discount factor @11% PV of costs Year 0 3,000,000 3,000,000 1 3,000,000 Year 1 330,000 231,000 180,000 51,000 0.9009 45,946 Year 2 330,000 231,000 180,000 51,000 0.8116 41,393 Year 3 330,000 231,000 180,000 51,000 0.7312 37,291 Year 4 330,000 231,000 180,000 51,000 0.6587 33,595 Year 5 330,000 231,000 180,000 51,000 0.5935 30,266 Total PV of purchase costs $ 3,188,491 b. Cost of Leasing Year Lease Payment Post Tax Cost of Lease payment Discount factor @11% PV of lease cost Year 1 700,000 490,000 1 490,000 as lease payment made at the beginning , the discount starts from second year Year 2 700,000 490,000 0.9009 441,441 Year 3 700,000 490,000 0.8116 397,695 Year 4 700,000 490,000 0.7312 358,284 Year 5 700,000 490,000 0.6587 322,778 Total PV of cost of leasing $ 2,010,198 c. Net Advantage of Leasing = 3,188,491-2,010,198 = $ 1,178,292
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