P17-4 L ease versus purchase JLB Corporation is attempting to determine whether

Question

P17-4 L ease versus purchase JLB Corporation is attempting to determine whether to lease or purchase research equipment. The firm is in the 40% tax bracket, and its after-tax cost of debt is currently 8%. The terms of the lease and of the purchase are as follows: Lease Annual end-of-year lease payments of $25,200 are required over the 3-year life of the lease. All maintenance costs will be paid by the lessor; insurance and other costs will be borne by the lessee. The lessee will exercise its option to purchase the asset for $5,000 at termination of the lease. Purchase The research equipment, costing $60,000, can be financed entirely with a 14% loan requiring annual end-of-year payments of $25,844 for 3 years. The firm in this case will depreciate the equipment under MACRS using a 3-year re- covery period. (See Table 4.2 on page 120 for the applicable depreciation per- centages.) The firm will pay $1,800 per year for a service contract that covers all maintenance costs; insurance and other costs will be borne by the firm. The firm plans to keep the equipment and use it beyond its 3-year recovery period. a. Calculate the after-tax cash outflows associated with each alternative. b. Calculate the present value of each cash outflow stream, using the after-tax cost of debt. c. Which alternative-lease or purchase-would you recommend? Why?

Explanation / Answer

P17-4

a) After Tax Outflows with each alternative Cash Outflows (Lease) Year 1 2 3 Annual Lease Payment $25,200.00 $25,200.00 $25,200.00 Less: Tax @ 40% $10,080.00 $10,080.00 $10,080.00 After Tax Lease Payment $15,120.00 $15,120.00 $15,120.00 Asset Purchase $5,000.00 Total After Tax Cash Flow $15,120.00 $15,120.00 $20,120.00 Cash Outflows (Purchases) Year 1 2 3 Annual Loan Payment $25,844.00 $25,844.00 $25,844.00 Interest Tax shield = $60,000 x 14% x 40% -$3,360.00 -$3,360.00 -$3,360.00 Depreciation Tax Shield = 60000 x 40% x MACRS Depreciation Rate -$7,920.00 -$10,800.00 -$3,600.00 After Tax Maintenance = $1800 x (1 - 40%) $1,080.00 $1,080.00 $1,080.00 After Tax Cash Flow $15,644.00 $12,764.00 $19,964.00 a) After Tax Outflows with each alternative Cash Outflows (Lease) Year 1 2 3 Annual Lease Payment $25,200.00 $25,200.00 $25,200.00 Less: Tax @ 40% $10,080.00 $10,080.00 $10,080.00 After Tax Lease Payment $15,120.00 $15,120.00 $15,120.00 Asset Purchase $5,000.00 Total After Tax Cash Flow $15,120.00 $15,120.00 $20,120.00 PV @ 8% 0.925925926 0.85733882 0.793832241 Present Value $14,000.00 $12,962.96 $15,971.90 $42,934.87 b) Cash Outflows (Purchases) Year 1 2 3 Annual Loan Payment $25,844.00 $25,844.00 $25,844.00 Interest Tax shield = Interest * x 40% -$3,360.00 -$2,383.14 -$1,269.46 Depreciation Tax Shield = 60000 x 40% x MACRS Depreciation Rate -$7,920.00 -$10,800.00 -$3,600.00 After Tax Maintenance = $1800 x (1 - 40%) $1,080.00 $1,080.00 $1,080.00 After Tax Cash Flow $15,644.00 $13,740.86 $22,054.54 PV @ 8% 0.925925926 0.85733882 0.793832241 Present Value $14,485.19 $11,780.58 $17,507.61 $43,773.37 Amortization Schedule Year Payment * Interest @ 14% Principal Ending bal 0 $60,000.00 1 $25,844.00 $8,400.00 $17,444.00 $42,556.00 2 $25,845.00 $5,957.84 $19,887.16 $22,668.84 3 $25,846.00 $3,173.64 $22,672.36 -$3.52 c) Lease would be recommended PV of cash outflows of lease is lessor than the after tax cash flow of purchases ,making lease less expensive

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