Suppose Procter and Gamble (P&G) is considering purchasing $15 million in new ma

Question

Suppose Procter and Gamble (P&G) is considering purchasing $15 million in new manufacturing equipment. If it purchases the equipment, P&G will depreciate it on a straight-line basis over five years, after which the equipment will be worthless. P&G will also be responsible for maintenance expenses of $1 million per year. Alternatively, it can lease the equipment for $4.2 million per year for the five years, in which case the lessor will provide necessary maintenance. Assume P&G’s tax rate is 35% and its borrowing cost is 7%.

a. What is the NPV associated with leasing the equipment versus financing it with the lease-equivalent loan?

b. What is the break-even lease rate—that is,what lease amount could P&G pay each year and be indifferent between leasing and financing a purchase?

Explanation / Answer

Answer:a If P&G buys the equipment, it will pay $15 million upfront, and have depreciation expenses of 15 / 5 = $3 million per year, generating a depreciation tax shield of 35% × 3 = $1.05 million per year for years 1–5. It will also have after tax maintenance expenses of $1 million × (1 – .35) =0.65 million. Thus, the FCF from buying is 1.05 – .65 = $0.4 million in years 1–5.

If it leases, the after-tax lease payments are $4.2 million × (1 – .35) = $2.73 million. Thus, the FCF of leasing versus buying is –2.73 – (–15) = 12.27 million in year 0, –2.73 – (0.4) = –3.13 million in years 1–4, and 0 – (0.4) = –0.4 million in year 5. We can determine the gain from leasing by discounting the incremental cash flows at P&G’s after-tax borrowing rate of 7%(1 – .35) = 4.55%

NPV(Lease-Buy) =$733,955.

Under these assumptions, the lease is more attractive than financing a purchase of the computer.

Answer: b. We can increase the after-tax lease payments by an amount with present value equal to the NPV in

(a). Thus,733,955

Increase in L 246,363=

. Therefore, the break-even lease rate is 4.2 + 0.246363 =

$4.446363 million per year.

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