Question

Principal Components is considering whether to lease or purchase some specialized equipment. The capital budgeting analysis indicating the equipment should be secured already has not been completed. The equipment has a five-year economic and tax life, and the company uses a straight-line depreciation method. The equipment costs $1,000,000 if purchased or it can be leased for five-years at $280,000 per year. The first lease payment is payable in advance. The equipment’s salvage value is estimated to be $100,000. Revenue is expected to be $350,000. Given that the firm has a marginal tax rate of 30% and an after-tax weighted average cost of capital of 10%, A. Determine the net advantage of leasing. B. Should the firm lease or purchase? C. Would the NAL be higher/lower if you used the after-tax cost of debt?

Answer 1

Based on the given data, pls find below steps, workings and answer highlighted in yellow:

Based on workings:

a) The Net advantage of leasing is negative $ 27773

b) Since there is no net advantage, it is recommeded for the firm to go for purchase of the equipment rather than leasing option;

c) With out knowing the actual after tax cost of debt, it would not be possible to complete comment on whether the NAL be higher or lower;

Year 3 1 2 4 5 Terminal 0 10,00,000 1,00,000 0 Currency in $ Buy Option Cost of Equipment Resale Book Value Revenue Depreciation EBIT Tax @ 30% Net Income 3,50,000 2,00,000 1,50,000 45,000 1,05,000 3,50,000 2,00,000 1,50,000 45,000 1,05,000 3,50,000 2,00,000 1,50,000 45,000 1,05,000 3,50,000 2,00,000 1,50,000 45,000 1,05,000 3,50,000 2,00,000 1,50,000 45,000 1,05,000 1,00,000 30,000 70,000 Net Operating Cash Flow Discounting Factor Discounted Cash Flow Cumulative Discounted Cash Flow Discounting Factor Net Present Value -10,00,000 1 -10,00,000 -10,00,000 10% 1,95,703 3,05,000 0.9091 2,77,273 -7,22,727 3,05,000 0.8264 2,52,066 -4,70,661 3,05,000 0.7513 2,29,151 -2,41,510 3,05,000 0.6830 2,08,319 -33,191 3,05,000 0.6209 1,89,381 1,56,190 70,000 0.5645 39,513 1,95,703 Year Currency in $ Lease Option 0 1 2 3 4 5 Terminal 3,50,000 Revenue Lease Expenses EBIT Tax @ 30% Net Income 2,80,000 -2,80,000 -84,000 -1,96,000 3,50,000 2,80,000 70,000 21,000 49,000 3,50,000 1,05,000 2,45,000 3,50,000 2,80,000 70,000 21,000 49,000 3,50,000 2,80,000 70,000 21,000 49,000 0 3,50,000 2,80,000 70,000 21,000 49,000 0 0 -1,96,000 1 0.5645 Net Operating Cash Flow Discounting Factor Discounted Cash Flow Cumulative Discounted Cash Flow Discounting Factor Net Present Value 2,45,000 0.9091 2,22,727 26,727 49,000 0.8264 40,496 67,223 49,000 0.7513 36,814 1,04,038 49,000 0.6830 33,468 1,37,505 49,000 0.6209 30,425 1,67,930 1,67,930 -1,96,000 -1,96,000 10% 1,67,930 Net Advantage to Leasing Net Present Value - Buy Option Net Present Value - Lease Option 1,95,703 1,67,930 NAL/ (Loss) -27,773