Waldrop Corporation must install $200 of new equipment in its Ohio plant. It can
ID: 2774084 • Letter: W
Question
Waldrop Corporation must install $200 of new equipment in its Ohio plant. It can obtain a bank loan for 100% of the required amount at 7% interest on the loan. Alternatively, the firm can leas the equipment on a 2-year lease, the payment would be $110 at the beginning of each year. Assume that Waldrop's tax rate is 38% and that the equipment's depreciation would be $100 per year. In either case, the equipment is worth nothing after 2 years and will be discarded. What is the cost of owning?
Waldrop Corporation must install $200 of new equipment in its Ohio plant. It can obtain a bank loan for 100% of the required amount at 3% interest on the loan. Alternatively, the firm can leas the equipment on a 2-year lease, the payment would be $110 at the beginning of each year. Assume that Waldrop's tax rate is 35% and that the equipment's depreciation would be $100 per year. In either case, the equipment is worth nothing after 2 years and will be discarded. What is the cost of leasing?
Explanation / Answer
Option 1:- Bank Loan
Total outflow of cash = First year interest + second year interest + Principle repayment
= (7% of 200) + (7% of 200) + 200
= 14 + 14 + 200
= $228
Thus, the cost of owning is $228.
Option 2 :- Lease
Calculate cost of capital = Market capital interest ( 1- current tax rate)
= 7% (1-.38)
= 4.34%
Calculate PV factor at beginning of second year = 100/100+4.34 = .9584
Calculate present value of Outflow
PV of lease Cost = 110*1 + 110*.9584
=215
Note :- Since payment was done in the beginning of the year first year PV factor will be 1 .
Thus, leasing will be better option for the company
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