1. Lease or Buy Mets nuclear research laboratory is contemplating leasing a diag

Question

1.         Lease or Buy     Mets nuclear research laboratory is contemplating leasing a diagnostic scanner (leasing is a common practice with expensive high-tech equipment). The scanner costs $6,300,000, and it would be depreciated straight-line to zero over four years. Because of radiation contamination, it actually will be completely worthless after four years. You can lease it for a lease payment of $1,875,000 per year for four years.

a.          Lease or Buy     Assume that the tax rate is 35 percent. You can borrow at 8 percent before taxes. Should the company lease or buy? (Calculate the Net Advantage to Leasing vs. Buying and see if it is positive or negative.) What is the Net Advantage to Leasing?

What is the net advantage (net disadvantage) to leasing from the Lessor’s viewpoint (assume that that Lessor is in the same tax bracket (35%) as the Lessee. (You do not need to do any more calculations; just think of the answer.)

Finding the Break-even Payment What would the lease payment have to be for both the lessor and lessee to be indifferent about the lease?

d.         Taxes and Leasing Cash Flows   Assume that Mets does not anticipate paying taxes for the next four years. What are the cash flows from leasing in this situation? (Calculate the Net Advantage to Leasing vs. Buying)

e.          Setting the lease payment.           If the lessor pays taxes at 35% but the lessee does not pay taxes, over what range of lease payments will the lease be profitable to both parties?

f.          MACRS Depreciation and Leasing          Rework part a. of problem #5 assuming that the scanner will be depreciated as three-year property under MACRS (remember the MACRS depreciation percentages are: 33%, 45%, 15%, 7%, for years 1, 2, 3, 4, respectively.) Assume Lessee’s tax rate is 35%, as we assumed in part a.

Explanation / Answer

Since, there are multiple parts to the question, the first 4 (a to d) have been answered.

_________

Part A)

The net advantage of leasing has been calculated with the use of following table:

To determine the NAL (Net Advantage to Leasing), we need to calculate the present value of cash flows with the use of after-tax interest rate. The present value of cash flows can be calculated with the use of following formula:

Present Value of Cash Flows = Cash Flow Year 1/(1+After-Tax Interest Rate)^1 + Cash Flow Year 2/(1+After-Tax Interest Rate)^2 + Cash Flow Year 3/(1+After-Tax Interest Rate)^3 + Cash Flow Year 4/(1+After-Tax Interest Rate)^4

After-Tax Interest Rate = 8*(1-35%) = 5.20%

NAL = 1,770,000/(1+5.20%)^1 + 1,770,000/(1+5.20%)^2 + 1,770,000/(1+5.20%)^3 + 1,770,000/(1+5.20%)^4 - 6,300,000 = $52,716.94 or $52,717

The lessee will have to pay $52,717 less if the equipment is taken on lease. Therefore, the equipment should be leased.

__________

Part B)

Since, the lessor is subject to same tax rate as lessee and the cost of debt also remains the same, we will use the NAL calculated in Part A as the basis for taking decision from the lessor's viewpoint. The NAL of $52,717 would mean a loss for the lessor as lesser amount would be recieved in comparision of what could have been received if the equipment had been sold.

Net Disadvantage to the Lessor = -$52,717

__________

Part C)

To determine the break even point, we need to find the payment that will make the NAL as 0. The payment can be calculated with the use of following equation:

NAL = 0 = Cost of Equipment - Cash Flow*PVIFA(After-Tax Interest Rate, Years) where PVIFA is the Present value interest factor for an annuity. The PVIFA value can be derived with the use of PVIFA tables/financial calculator.

__________

Using the above equation, we get,

NAL = 0 = 6,300,000 - Operating Cash Flow*PVIFA(5.2%,4)

Rearranging Values, we get,

Operating Cash Flow = 6,300,000/3.5295 = $1,784,955.38

Now, we can calculated the Break Even Lease Payment with the use of following formula:

Break Even Lease Payment = (OCF - Depreciation Tax Shield)/(1-Tax Rate) = (1,784,955.38 - 551,250)/(1-35%) = $1,898,008.28

__________

Part D)

As there are no taxes, we will use the Pre-Tax Interest Rate to arrive at the NAL. The NAL can be calculated with the use of following formula:

NAL = = Cash Flow Year 1/(1+Pre-Tax Interest Rate)^1 + Cash Flow Year 2/(1+Pre-Tax Interest Rate)^2 + Cash Flow Year 3/(1+Pre-Tax Interest Rate)^3 + Cash Flow Year 4/(1+Pre-Tax Interest Rate)^4 - Cost of the Equipment

__________

Using the values calculated in Part 1, we get

NAL = 1,770,000/(1+8%)^1 + 1,770,000/(1+8%)^2 + 1,770,000/(1+8%)^3 + 1,770,000/(1+8%)^4 - 6,300,000 = -$437,535 [in this case, it is better for lessee to buy the equipment]

Year 0 1 2 3 4 Cost of the Equipment 6,300,000 Lease Payments After Tax (1,875,000*(1-35%)) 1,218,750 1,218,750 1,218,750 1,218,750 Depreciation Tax Shield (6,300,000/4*35%) (551,250) (551,250) (551,250) (551,250) Net Cash Flow $6,300,000 $1,770,000 $1,770,000 $1,770,000 $1,770,000

Related Questions

Navigate

• Browse (All)
• Browse 1
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.