1 Assuming 0% taxes. Equipment can be leased at $12000 per year (first payment a
ID: 2797489 • Letter: 1
Question
1 Assuming 0% taxes. Equipment can be leased at $12000 per year (first payment at end of year) for nine years or purchased at a cost of $68000. The company has a weighted average cost of capital of 12%. A bank has indicated that it would be willing to make the loan of $68000 at a cost of 10%. There is no salvage value. Should the company buy or lease?
A none of them
B Buy; PV of Buy option lower than Lease option
C Buy; PV of Lease option lower than Buy option
D Lease; PV of Lease option lower than Buy option
E Lease; PV of Buy option lower than Lease option
2 Now assume a marginal tax rate of 40% and that a loan can be obtained from the bank at a cost of 9%. Should the firm buy or lease? The PV of the depreciation expense is 60% of the original investment. Assume a 5.4% discount rate. Explain your answer on Excel.
A Lease; PV of Lease option lower than Buy option
B Lease; PV of Buy option lower than Lease option
C Buy; PV of Buy option lower than Lease option
D none of them
E Buy; PV of Lease option lower than Buy option
3 Referring to Q2. If the lease payments start at the beginning of the year, would your recommendation change? How?
Explain your answer on Excel.
A Buy; PV of Buy option lower than Lease option
B Lease; PV of Lease option lower than Buy option
C Lease; PV of Buy option lower than Lease option
D Buy; PV of Lease option lower than Buy option
E none of them
Explanation / Answer
1. The correct option is D Lease; PV of Lease option lower than Buy option.
Explanation:
Equipment can be leased at $12000 per year (first payment at end of year) for nine years
or purchased at a cost of $68000.
Given, company cost of capital = 12%.
Discounting factor
Year
Cash flows
At 12%
PV of cash flows
1
12,000
0.89286
10,714.29
2
12,000
0.79719
9,566.33
3
12,000
0.71178
8,541.36
4
12,000
0.63552
7,626.22
5
12,000
0.56743
6,809.12
6
12,000
0.50663
6,079.57
7
12,000
0.45235
5,428.19
8
12,000
0.40388
4,846.60
9
12,000
0.36061
4,327.32
63,939.00
If the equipment is leased, then cost = $63,939
Therefore, It is better to lease the equipment
2 . The correct option is: A Lease; PV of Lease option lower than Buy option .
Explanation:
Computation of PV of cost of leasing = $50,276.91
Discounting factor
Year
Cash flows
Tax savings from lease = cash flows *40%
Net cash flows = cash flows - tax savings
At 5.4%
PV of cash flows
1
12,000
4,800
7,200
0.94877
6,831.12
2
12,000
4,800
7,200
0.90016
6,481.14
3
12,000
4,800
7,200
0.85404
6,149.09
4
12,000
4,800
7,200
0.81028
5,834.05
5
12,000
4,800
7,200
0.76877
5,535.15
6
12,000
4,800
7,200
0.72938
5,251.57
7
12,000
4,800
7,200
0.69202
4,982.51
8
12,000
4,800
7,200
0.65656
4,727.24
9
12,000
4,800
7,200
0.62292
4,485.05
50,276.91
Computation of PV of cost of Buying = investment + interest * PV factor at 5.4% for 9 years - tax shield on depreciation
= 68,000 + 6,120*6.983 - 60% *68,000*(1-40%)
=68,000+ 42,735.96 - 24,480
PV of cost of Buying = 86,255.96
3 The correct option is: B Lease; PV of Lease option lower than Buy option
Explanation:
Discounting factor
Year
Cash flows
Tax savings from lease
Net cash flows
At 5.4%
PV of cash flows
1
12,000
4,800
7,200
1
7,200.00
2
12,000
4,800
7,200
0.94877
6,831.12
3
12,000
4,800
7,200
0.90016
6,481.14
4
12,000
4,800
7,200
0.85404
6,149.09
5
12,000
4,800
7,200
0.81028
5,834.05
6
12,000
4,800
7,200
0.76877
5,535.15
7
12,000
4,800
7,200
0.72938
5,251.57
8
12,000
4,800
7,200
0.69202
4,982.51
9
12,000
4,800
7,200
0.65656
4,727.24
52,991.86
Discounting factor
Year
Cash flows
At 12%
PV of cash flows
1
12,000
0.89286
10,714.29
2
12,000
0.79719
9,566.33
3
12,000
0.71178
8,541.36
4
12,000
0.63552
7,626.22
5
12,000
0.56743
6,809.12
6
12,000
0.50663
6,079.57
7
12,000
0.45235
5,428.19
8
12,000
0.40388
4,846.60
9
12,000
0.36061
4,327.32
63,939.00
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.