Suppose Clorox can lease a new computer data processing system for $975,000 per

Question

Suppose Clorox can lease a new computer data processing system for $975,000 per year for five years. Alternatively, it can purchase the system for $4.25 million. Assume Clorox has a borrowing cost of 7% and a tax rate of 35%, and the system will be obso- lete at the end of five years.

a. If Clorox will depreciate the computer equipment on a straight-line basis over the next five years, and if the lease qualifies as a true tax lease, is it better to finance the purchase of the equipment or to lease it?

b. Suppose that if Clorox buys the equipment, it will use accelerated depreciation for tax purposes. Specifically, suppose it can expense 20% of the purchase price immediately and can take depreciation deductions equal to 32%, 19.2%, 11.52%, 11.52%, and 5.76% of the purchase price over the next five years. Compare leasing with purchase in this case.

Explanation / Answer

Question a. Depreciation Net After Tax Cashflows pv factor Present Year Savings of system Saving Savings(65%) +Depreciation at 7% Value 1 975000 425000 550000 357500 782500 0.93458 731308.41 2 975000 425000 550000 357500 782500 0.87344 683465.80 3 975000 425000 550000 357500 782500 0.81630 638753.09 4 975000 425000 550000 357500 782500 0.76290 596965.50 5 975000 425000 550000 357500 782500 0.71299 557911.69 Total 3208404.49 So, Present Value of Lease is lesser than Purchase value of the system. It is better to take lease. Question b. Depreciation Net After Tax Cashflows pv factor Present Year Savings of system Saving Savings(65%) +Depreciation at 7% Value 1 975000 1360000 -385000 -250250 1109750 0.93458 1037149.53 2 975000 816000 159000 103350 919350 0.87344 802995.89 3 975000 489600 485400 315510 805110 0.81630 657209.58 4 975000 489600 485400 315510 805110 0.76290 614214.56 5 975000 244800 730200 474630 719430 0.71299 512943.65 Total 3624513.22 So, Present Value of Lease is lesser than Purchase value of the system. It is better to take lease.

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