8.3. Royal Troon Inc is planning to lease a computer for $6,500 per annum, payab

Question

8.3. Royal Troon Inc is planning to lease a computer for $6,500 per annum, payable in advance, for a period of 4 years. The lease will cover maintenance expenses. Royal Troon’s chairman feels that if he buys the same computer he should be able to sell it at 45% of the purchase price after 4 years. However, in case of purchase, the company must pay annual maintenance expenses of $600 at the end of each year. The pretax cost of debt of Royal Troon is 7% and its income tax rate is 40%. If Royal Troon buys the computer, it will depreciate it fully in 4 years. What is the maximum price that Royal Troon should pay for this computer? Assume that Royal Troon can take the tax credit for lease payments a year later.

ANSWER: $33,625.37; PLEASE SHOW SOLUTIONS

Explanation / Answer

Net Income earned by Royal Troon Inc per year $ Lease Income 6500 Maintenance Costs -600 Pre Tax Income 5900 Tax Impact @ 40% -2360 Post Tax Income 3540 Cost of Debt (Discounting Rate) = 7% Assume that the cost of buying the Computer is X Selling Price thereof = 0.45X For working out the value of X, we use the Net Present Value approach Using this approach, the price works out to $ 7,414. Using the cost of $ 7,414, the benefit per year will be $ 6,500, which is allowable as a tax credit in the year later.

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