Company X is considering taking investment for $400,000. This investment can be

Question

Company X is considering taking investment for $400,000. This investment can be financed entirely with the help of a bank loan or by means of leasing. The asset will be used for 5 years (rate of linear depreciation). Bank loan for 5 years bears interest at 10% per annum. Payment loans are decreasing (fixed installments and decreasing interest). They are paid at the end of each year. Lease payments are spread over a period of 5 years and amount to $82,000 x 5 (assuming that they are paid at the end of the year). The first payment is $40,000 and is paid in year t = 0. Upon termination, the company buys back the asset for $10,000 (t = 5).

Please compare the profitability of credit and leasing as sources of financing the assumptions of the corporate income tax rate (19%) remains unchanged throughout the life of the asset and the company over the same period showed tax income. As the discount rate in both variants can embrace the cost of bank credit. Assume the asset is depreciated by the person who grants the lease. Profitability of these forms evaluate by comparing the NPV of leasing costs and the cost of purchasing on credit.

Explanation / Answer

Value of investment 400000 Period of use 5 years Loan interest rate 10% Taken as discount rate Annual loan instalment =400000/5 80000 payable at the end of year Depreciation 5 years straight line Lease payments In year zero 40000 Next 5 years 82000 Corporate tax rate 19% cash flows for loan financing Year 0 1 2 3 4 5 Initial investment -400000 Loan amount 400000 Annual Depreciation 80000 80000 80000 80000 80000 Interest on Loan 40000 32000 24000 16000 8000 Depreciation + Loan Interest 117720 109872 102024 94176 86328 (Depn+Lon int)*(1-Tax rate) Loan Instalment 80000 80000 80000 80000 80000 Net Cash outflow 82280 82128 81976 81824 81672 (Depn+Loan int+loan inst-tax shield) Total cash flows 0 82280 82128 81976 81824 81672 Discount rate 10% Discount factor (1/(1+disc rate)^year) 1 0.909091 0.826446 0.751315 0.683013 0.620921 Discounted cash outflows 0 74800 67874.38 61589.78 55886.89 50711.89 (cash flow * discount factor) Net Present value of Loan financing =-SUM(74800+67874.38+61589.78+55886.89+50711.89) -310863 Cashflows for lease financing year 0 1 2 3 4 5 Lease payments -40000 -82000 -82000 -82000 -82000 -82000 Cost of buyback of asset -10000 Total cash outflows -40000 -82000 -82000 -82000 -82000 -92000 Discount rate 10% Discount factor (1/(1+disc rate)^year) 1 0.909091 0.826446 0.751315 0.683013 0.620921 Discounted cash flows -40000 -74545.5 -67768.6 -61607.8 -56007.1 -57124.8 Net Present value of leasing =sum(-40000-74545.50-67768.60-61607.80-56007.10-57124.80) -357054 Comparing the two options, we find that the net present value of loan financing has lesser net present value of cash outflows it is advisable to opt for loan financing instead of leasing.

Related Questions

Navigate

• Browse (All)
• Browse C
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.