Question

Your company (Acme Iron) is considering leasing a new computer, you and your team need to perform analysis to support the decision making process. The lease lasts for 9 years. The lease calls for 10 payments of $10,000 per year with the first payment occurring immediately. The computer would cost $70,650 to buy and would be straight-line depreciated to a zero salvage over 9 years. The actual salvage value is negligible because of technological obsolescence. The firm can borrow at a rate of 8%. The corporate tax rate is 30%.

1. What is the after-tax cash flow from leasing relative to the after-tax cash flow from purchasing in years 1-9?

1. What is the after-tax cash flow from leasing relative to the after-tax cash flow from purchasing in year 0?

1. What is the NPV of the lease relative to the purchase?

1. What would the after-tax cash flow in year 9 be if the asset had a residual value of $500 (ignoring any possible risk differences)?

1. Do you have a recommendation?

Answer 1

1: Years 1-9

After tax CF of leasing = -7000

After tax cf of purchase = 2355

2: Year 0

After tax CF of leasing = -7000

After tax cf of purchase = -70650

3: Lease

NPV

-50728.22

Buy

NPV

-55938.58

4: After tax CF in year 9 = 2705 (Buy)

Lease = -7000

5: Lease is a better option since it has higher NPV

Workings

	Lease		Buy-No Salvage				Buy-With Salvage
Year	Cash flow		Initial cost	Tax shield	Net CF		Initial cost	Tax shield	Salvage after tax	Net CF
0	-7000		-70650		-70650		-70650			-70650
1	-7000			2355	2355			2355		2355
2	-7000			2355	2355			2355		2355
3	-7000			2355	2355			2355		2355
4	-7000			2355	2355			2355		2355
5	-7000			2355	2355			2355		2355
6	-7000			2355	2355			2355		2355
7	-7000			2355	2355			2355		2355
8	-7000			2355	2355			2355		2355
9	-7000			2355	2355			2355	350	2705