The X company is considering the acquisition of a new processor that has an esti
ID: 2635097 • Letter: T
Question
The X company is considering the acquisition of a new processor that has an estimated installed
cost of $57,000. The processor has an expected life of 5 years and will be depreciated over a 5
year ACRS life to a zero salvage value. However, it is expected that the processor can be sold at
that time for $6,000. If purchased, the entire $57,000 would be borrowed at an interest rate of
9%. A capital budgeting analysis results in a positive NPV for the project. An alternative to
purchase is to lease the asset for an annual lease payment of $13,500. The lease includes
maintenance services estimated to cost Company C $3,000 per year if they were not included in
the lease payment. Company C
Explanation / Answer
Option 1
If the X company decides to buy the processor as per option 1 by taking entire amount as loan then the result would be as under -
Cost of processor - $57000
Depreciation cost $ 51000
($57000 - $ 6000)
Interest cost as per working below $15390
Tax rate @ 34% on cost $ 22572.60
($51000+$15390)
Total tax benefit under option 1 is $ 22572.60
Working
It is assumed that the company pays off its loan in below manner and the resulting interest calculation
Option 2
If X company decides to lease the processor
Cost for leasing the processor for 5 years $ 67500
(13500*5)
Cost of maintenance for 5 years $ 15000
($3000*5)
Total cost under option 2 $ 82500
Tax @ 34% on total cost $ 28,050
Benefit to X company if they go for option 2 of leasing is $ 28,050.
From above calculation measuring the benefit the company should go for leasing of processor.
Note - There can be a variation in calculation as I have assumed that company pays of its loan on yearly basis as a result the overall benefit under option 1 of buying has gone down.
However, if the copany doesnot pay off the loan then the benefit would be under option 1 as under -
Depreciation cost - $51000
Interest cost - $ 25650
($57000*9%*5 years)
Total cost $ 76650
Tax @ 34% on total cost $ 26061
Total benefit under option 1 of buying the processor if the company doesnot pay off its loan is only $ 26061 further proving that option 2 of leasing is better.
Another reason why option 2 of leasing is better because in option 1 of buying asset the company gets a resale of $ 6000 on selling the machine owing to which the tax benefit on $ 6000 has gone down. So as a result benefit has reduced by $ 2040.
So the company should go for option 2 that should lease the processor.
Year Repayment Cost Interest 1 $ 57000 $5130 2 $ 11400 $ 45600 $4104 3 $ 11400 $ 34200 $3078 4 $ 11400 $ 22800 $2052 5 $ 11400 $ 11400 $1026 6 $11400 0 0 Total $ 15390Related Questions
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