XYZ Corp. is looking to lease some machinery from CamCorp. The cost of the machi

Question

XYZ Corp. is looking to lease some machinery from CamCorp. The cost of the machinery is $30,000 and the annual lease payments made at the beginning of each year are $8,000. The lease will last for 3 years, but the asset will be depreciated using a 5-year MACRS schedule. CamCorp. Pays $750 a year in property taxes, which represent “additional operating costs” and are made at the end of each year. The estimated salvage value of the asset at the end of the third year is $4,000. The corporate tax rate for both firms is 40%. If XYZ were to purchase the machinery their pre-tax cost of borrowing would be 10%. Further, XYZ has an after-tax WACC of 15%. Should XYZ Corp. lease the equipment?

Explanation / Answer

Answer : If Machine taken on lease

Cash out flow after tax PV of annuity of $ 1 at 15% total Present value

for 3 years

4800 2.283 10958.40

(cash out flow = lease payment - tax sheild = 8000-8000*40% = 4800)

If machine purchase

Cash saving

salvage value 4000 * 0.658 2632

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Total Saving 16844

intial cash out lays 30000

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NPV of Cash out flow 13156

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After calulation of both option, Company sho;d opt the lease option.

Year interest paid(a) deprication(b) tax save @40%(c) cash flow saving d= b+c-a Pv factor @15% Pv of cash saving 1 3000 6000 3600 6600 0.870 5742 2 3000 7680 4272 8952 0.756 6768 3 3000 3133 2453 2586 0.658 1702 Total Saving 14212

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