The equipment costs $1,000,000, and, if it were purchased, Lewis could obtain a

Question

The equipment costs $1,000,000, and, if it were purchased, Lewis could obtain a term loan for the full purchase price at a 10 percent interest rate. Although the equipment has a six-year useful life, it is classified as a special-purpose computer, so it falls into the MACRS three-year class. If the system were purchased, a four-year maintenance contract could be obtained at a cost of $20,000 per year, payable at the beginning of each year. The equipment would be sold after four years, and the best estimate of its residual value at that time is $200,000. However, since real-time display system technology is changing rapidly, the actual residual value is uncertain. As an alternative to the borrow-and-buy plan, the equipment manufacturer informed Lewis that Consolidated Leasing would be willing to write a four-year guideline lease on the equipment, including maintenance, for payments of $260,000 at the beginning of each year. Lewis's marginal federal-plus-state tax rate is 40 percent. You have been asked to analyze the lease-versus-purchase decision, and in the process to answer the following questions:

Question 1a. Answer these questions one at a time to see the effect of the change on NAL. That is, starting with the original numbers you used for questions a. and b., what is the NAL if: 1. interest rate increases to 12 percent:

b. the tax rate falls to 34 percent

maintenance cost increases to $25,000 per year

C. residual value falls to $,1050,000

d. the system price increases to $1,050,000

e Do the changes in d. make leasing more or less attractive? Explain.

Explanation / Answer

So, in purchase deecision you still have to recover 792,291.12$ on NPV basis. Assuming taxes are required to pay even, when there is loss and asset is salable at this period.

Lease will save depriciation as well as taxes, assume that the dealer will charge for asset with Tax included.

Values after change as presented in b,c,d and e.

Lease is more attractive as incremental income is more from lease rather than purchase.as asset has become more expensive and interest rate has also increase. outflow is reduced to a great extent to the company as well and it saves it self from tax benefits as well as there is no income but still company has to pay tax after intial investment of 1050000$ which are not required in case of a lease.

Purchase Decision 1 2 3 4 Particulars Year 0 Year 1 Year 2 Year 3 Year 4 Equipment purchased $ 1,000,000.00 Maintenance cost $      20,000.00 $      20,000.00 $    20,000.00 $    20,000.00 Depriciation $    333,300.00 $    296,348.15 $ 148,100.00 $    74,100.00 Loan obtained (inflow) $    100,000.00 $    100,000.00 $ 100,000.00 $ 100,000.00 Net income $ (253,300.00) $ (216,348.15) $ (68,100.00) $      5,900.00 Tax @ 40% $ (101,320.00) $    (86,539.26) $ (27,240.00) $      2,360.00 Add back depriciation $    333,300.00 $    296,348.15 $ 148,100.00 $    74,100.00 Sale back of the asset ( assume same is possible) $ 200,000.00 Net inflow $    (21,320.00) $      (6,539.26) $    52,760.00 $ 282,360.00 NPV factors 0.909090909 0.826446281 0.751314801 0.683013455 Npv of inflows $    (19,381.82) $      (5,404.35) $    39,639.37 $ 192,855.68 $    207,708.88 Net Present value $ (792,291.12)

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