A manager has decided to buy a widget. Two alternative financing methods are ava
ID: 2780261 • Letter: A
Question
A manager has decided to buy a widget. Two alternative financing methods are available: (A) use a financial lease or (B) purchase the widget using owner financing and borrowed capital. The financial lease is a 3 year lease with annual lease payments of $6,500 paid at the beginning of each year (a lease payment is tax deductible; assume it can be claimed at the beginning of each year). The manager can buy the widget for $20,000 and sell it again in 3 years for $5,000. A bank will loan $15,000 and the loan will be fully amortized at 10% over 3 years with annual payments. The IRS will allow the widget to be depreciated over 10 years. The marginal tax rate is 15%. The manager requires at least a 10% pre-tax return on capital. Assume that the inflation rate is 0%. Should the manager buy or lease?
What is the annual depreciation if you purchase the widget (absolute value)?
$6,000
$6,350
$1,700
$2,000
None of the above
What is the accumulated depreciation over the first three years if you purchase the widget (absolute value)?
$6,000
$6,350
$1,700
$2,000
None of the above
What is the annual tax savings from depreciation if you purchase the widget (absolute value)?
$1,700
$900
$300
$2,000
None of the above
What is the present value of the after-tax terminal value if you purchase the widget (absolute value)?
$14,262
$5,584
$766
$4,971
None of the above
$14,262
$5,584
$766
$4,971
None of the above
Explanation / Answer
1) Annual Depreciation = Cost of Widget / Life of widget = $20,000 / 10 years = $2000 per year
2) Accumulated Depreciation would be $2000 each year for 3 years, i.e., $6,000.
3) Annual Tax savings from depreciation = $2000 x 15% = $300
4) Terminal Value is given as $5,000. Remaining value of widget after 3 years = $20000 - $6000 = $14000
Tax shield on loss on sale = (14000 - 5000) x 15% = $1,350
After Tax terminal Value = $5,000 + tax shield on loss = $5000 + $1350 = $6,350
Post tax return required = 10% x (1 - 0.15) = 8.5%
Present Value = $4250 x PVF (8.5% , 3rd Year) = $6350 x 0.78290809842 = $4,971
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