A company\'s mobile radio system is due for replacement. The replacement system
ID: 2619913 • Letter: A
Question
A company's mobile radio system is due for replacement. The replacement system will cost $4,500,000 and will have an economic life of six years. A finance company has offered a six-year lease proposal with monthly payments of $75,000 and a residual value of $900,000. The lease payments are fully tax deductible. The tax rate is 35%, and tax payments are made in the same year as the income is earned. The full cost of the communications system is allowable for depreciation. The tax life is the same as the economic life. a) If the discount rate for NPV calculations is 7.5%, should you opt to lease the communications system? [11] b) What is the internal rate of return (IRR) for the lease option? [2]Explanation / Answer
a) In order to decide whether or not to opt for lease option, we have to calculate NPV under both the alternatives.
NPV if lease is not taken:
Outflow at time 0 = $ 4,500,000
we have been told that full value of system is allowed as depreciation and that economic life = tax life = 6 years
which means we use straight line method to depreciate the system in 6 years.
Depreciation per annum = 4,500,000/6 = $ 750,000
Tax benefit on depreciation per annum (i.e. inflow per annum) = 750,000 * 35% = $ 262,500
NPV =Present value of outflow - Present value of tax benefit on depreciation
NPV = 4,500,000 - (262,500* 1/1.0756)
NPV = -3,267,865
NPV if lease is taken:
(outflow) Lease payment annually = 75000*12 = $ 900,000
(inflow) Tax benefit on lease payment = 900,000 * 35% = $ 315,000
Net outflow each year on account of leases = 900,000 - 315,000 = $ 585,000
(inflow) Salvage value at the end of 6 years = 900,000
NPV = Present value of inflow - Present value of outflow
NPV = Present value of 900,000 received at the end of 6 years - Present value of 585000 annual outflow for 6 years
NPV = - 2,162,735
We see that present value of net outflow in lease option is lower than that in option where no lease is taken, therefore it is advisable to opt for lease.
(b) IRR is that rate at which present value of inflow equals the present value of outflow.
We can find IRR by using trial and error method or directly on our financial calculators.
Here we go for trail and error method,
IRR = Present value of 585000 outflow from 1-5 = Present value of 315000 at the end of yr 6
IRR = 64.88%
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