Company A needs new equipment for a project and is deciding whether it makes mor

Question

Company A needs new equipment for a project and is deciding whether it makes more sense to lease or buy. The firm's tax rate is 40% and this project will last 5 years. If the firm leases the equipment, it will do so at an annual cost of $1.25 million per year payable at the beginning of each year, and it will be structured as a taxoriented lease. Lease payments will cover all service and maintanance. If the firm buysthe equipment, it will cost $5 million.  The firm will pay for it by borrowing money from a bank at 8 percent.  The asset will be depreciated using MACRS and is in the 3year asset class. In addition, the firm will buy a service contract through the manufacturer to cover maintenance and service at an annual rate of $200,000 payable at the beginning of each year.   The equipment will be able to be sold at the end of 5 years for $475,000.   Calculate the net advantage to leasing (NAL)

Explanation / Answer

Statement showing Net advantage of leasing:

Working note

(1) Annual Interest = $5000000 x 8% = $400000

P.V. of annual interest = $400000 x 3.993 = $1597200

(2) Tax savings on lease rents = $1250000 x 40% = $500000

P.V. of annual interest = 500000 x 3.993 = 1996500

(3) P.V. of savings in maintenance cost = 200000 x 4.312 = 862400

(4) Statement showing tax savings on depreciation

P.V. of tax savings in depreciation = 1555960

(5) P.V. of lease rentals = 1250000 x 4.312 = 5390000

(6) loss of terminal value = 475000 x 0.681 = 323475

(7) Loss of tax savings on interest = 400000 x 40% x 3.993 = 638880

(8) Loss of tax savings on maintenance cost = 80000 x 3.993 = 319440

Particulars Amount Advantages of leasing Savings in payment of Interest 1597200 Add: Tax savings on lease rents 1996500 Add: P.V. of savings in payment of maintenence cost 662400 (A) 4256100 Cost of leasing P.V. of loss of tax savings on depreciation 1555960 Add: P.V. Payment of lease rents 5390000 Add: P.V. of loss of Terminal Value 323475 Add: P.V. of loss of tax savings on interest 638880 Add: P.V. of loss of tax savings on maintenance cost 319440 (B) 8227755 NAL (A-B) (3971655)

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