Your boss asks you to review an option to lease an equipment storage facility th

Question

Your boss asks you to review an option to lease an equipment storage facility that the firm needs. You are to compare it with the purchase of the facility. The following information are pertinent to your decision: a) The facility will be needed for ten years b) If the facility is leased, the lessor will conduct all maintenance; if purchased, your firm must conduct maintenance c) Facility maintenance is expected to cost $67000 per year d) The cost to lease the facility is $325000 per year at the beginning of each year e) The purchase price of the facility is $5000000 and the market value at the end of ten years is expected to be $6000000 f) The before-tax cost of debt is 9%, and the tax rate is 40% g) The company's current EBIT is $2000000 (before leasing or purchasing the facility)

Assuming that the facility has a ten-year depreciation life for tax purposes (i.e. it can be fully depreciated over ten-years), compute the NPV for each option and based on the cost, indicate your decision (round to nearest $1,000).

A BUY; BUY NPV = -1610000, LEASE NPV = -1662000

B none of them

C LEASE; LEASE NPV = -1484000, BUY NPV = -1788000

D LEASE; LEASE NPV = -1610000, BUY NPV = -1662000

E BUY; BUY NPV = -1484000, LEASE NPV = -1788000

Assuming that the facility has a seven-year depreciation life for tax purposes (i.e. it will not be fully depreciated by end of ten years), compute the NPV for each option and based on the cost, indicate your decision (round to nearest $1,000).

A BUY; BUY NPV = -1484000, LEASE NPV = -1645000

B none of them

C BUY; BUY NPV = -1519000, LEASE NPV = -1610000

D LEASE; LEASE NPV = -1484000, BUY NPV = -1645000

E LEASE; LEASE NPV = -1519000, BUY NPV = -1610000

Explanation / Answer

(i) Post tax Kd = 9 x (1-0.4) = 5.40% (Discount rate) Cost of leasing - Year Lease payments Tax savings on leaase Post tax lease PV factors PV 0 325000 325000 1 325000 1 325000 130000 195000 0.948766603 185009.4877 2 325000 130000 195000 0.900158068 175530.8232 3 325000 130000 195000 0.854039912 166537.7829 + 4 325000 130000 195000 0.810284547 158005.4867 5 325000 130000 195000 0.768770917 149910.3289 - 6 325000 130000 195000 0.729384172 142229.9136 7 325000 130000 195000 0.692015344 134942.992 8 325000 130000 195000 0.656561047 128029.4042 9 325000 130000 195000 0.622923195 121470.0229 10 130000 -130000 0.591008723 -76831.13405 1609835.108 Or Approx 1610000 Cost of buying - - Loan repayment schedule - Year Beginning balance Installments Interest Principle Ending balance Interest tax savings(Intt. Tax rate) Post tax maintainance cost (Cost x (1-t)) Depreciation tax savings (NOTE) Net outflow (Installments + maintainance cost - DTS - ITS) PV factors @ 5.4% PV of net cash flows 1 5000000 779100.45 450000 329100.45 4670899.55 180000 40200 200000 439300.45 0.948766603 416793.5954 2 4670899.55 779100.45 420380.9595 358719.49 4312180.06 168152.3838 40200 200000 451148.07 0.900158068 406104.5711 3 4312180.06 779100.45 388096.2054 391004.24 3921175.82 155238.4822 40200 200000 464061.97 0.854039912 396327.442 4 3921175.816 779100.45 352905.8235 426194.63 3494981.19 141162.3294 40200 200000 478138.12 0.810284547 387427.9301 5 3494981.19 779100.45 314548.3071 464552.14 3030429.05 125819.3228 40200 200000 493481.13 0.768770917 379373.9385 6 3030429.048 779100.45 272738.6143 506361.84 2524067.21 109095.4457 40200 200000 510205.00 0.729384172 372135.4543 7 2524067.213 779100.45 227166.0491 551934.40 1972132.81 90866.41965 40200 200000 528434.03 0.692015344 365684.4567 8 1972132.812 779100.45 177491.9531 601608.50 1370524.32 70996.78124 40200 200000 548303.67 0.656561047 359994.8305 9 1370524.316 779100.45 123347.1884 655753.26 714771.05 49338.87537 40200 200000 569961.57 0.622923195 355042.2845 10 714771.0546 779100.45 64329.39492 714771.05 0.00 25731.75797 40200 200000 593568.69 0.591008723 350804.2747 3789688.778 Less : PV of post tax salvage value - (Note) 2127631.404 1662057.373 or approx - 1662000 Answer is   D NOTES - Equipmemt cost 5000000 Depreciation tax savings - Annual Depreciation 5000000/10 = 500000 Tax savings on depreciation 50000 x 0.4 = 200000 PV of salvage value = post tax salvage value (6000000 x (1- 0.4) = 3600000 PV factor for 10th year = 0.591008723 Pv of post tax SV = 2127631.404 It will not effect the cost of leasing - Cost of buying - - Loan repayment schedule - Year Beginning balance Installments Interest Principle Ending balance Interest tax savings(Intt. Tax rate) Post tax maintainance cost (Cost x (1-t)) Depreciation tax savings (NOTE) Net outflow (Installments + maintainance cost - DTS - ITS) PV factors @ 5.4% PV of net cash flows 1 5000000 779100.45 450000 329100.45 4670899.55 180000 40200 285714.2857 353586.16 0.948766603 335470.7437 2 4670899.55 779100.45 420380.9595 358719.49 4312180.06 168152.3838 40200 285714.2857 365433.78 0.900158068 328948.1653 3 4312180.06 779100.45 388096.2054 391004.24 3921175.82 155238.4822 40200 285714.2857 378347.68 0.854039912 323124.0209 4 3921175.816 779100.45 352905.8235 426194.63 3494981.19 141162.3294 40200 285714.2857 392423.83 0.810284547 317974.9689 5 3494981.19 779100.45 314548.3071 464552.14 3030429.05 125819.3228 40200 285714.2857 407766.84 0.768770917 313479.2884 6 3030429.048 779100.45 272738.6143 506361.84 2524067.21 109095.4457 40200 285714.2857 424490.72 0.729384172 309616.811 7 2524067.213 779100.45 227166.0491 551934.40 1972132.81 90866.41965 40200 285714.2857 442719.74 0.692015344 306368.8559 8 1972132.812 779100.45 177491.9531 601608.50 1370524.32 70996.78124 40200 748303.67 0.656561047 491307.04 9 1370524.316 779100.45 123347.1884 655753.26 714771.05 49338.87537 40200 769961.57 0.622923195 479626.9234 10 714771.0546 779100.45 64329.39492 714771.05 0.00 25731.75797 40200 793568.69 0.591008723 469006.0194 3674922.837 Less : PV of post tax salvage value - (Note) 2127631.404 1547291.432 or approx - 1662000 Answer is   D NOTES - Equipmemt cost 5000000 Depreciation tax savings - Annual Depreciation 5000000/7 = 714285.7143 Tax savings on depreciation 285714.2857 PV of salvage value = post tax salvage value (6000000 x (1- 0.4) = 3600000 PV factor for 10th year = 0.591008723 Pv of post tax SV = 2127631.404 The language of question is ambiguious as it says that the life is 7 years and then says that asset is not fully depreciated in 10 years. I have assumed the life of asset as 7 years, and hence solve the ques. Please provide feedback…. Thanks in advance…. :-)

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