JLB Corporation is attempting to determine whether to lease or purchase research

Question

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 debtis currently 8%. the terms of the lease and of the purchase are as follows:

LEASE: Annual end-of-year lease payment 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 cost will be borne by the lesse. the lesse will excercise its option to purchase the asset for $5,000 at termination of 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 MARCS using a 3 year recovery period. The firm will pay 1,800 per year for a service contract the 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 outflow associated with each

B. Calculate the present value of each outflow stream,using the after-tax cost of debt.

C. Which Alternative-Lease of Purchase-would you recommend? Why

Please Show Work

Explanation / Answer

A. Calculation of the after-tax cash outflow LEASE: Annual end-of-year lease payment (Net of tax) = $25,200* (1-0.40) $ 15,120.00 Purchase price at the end of year 3 $    5,000.00 PURCHASE: Annual installment of loan $ 25,844.00 Annual service contract fees (Net of tax) = 1800 * (1-0.40) $    1,080.00 B. Calculation of the present value of each outflow stream,using the after-tax cost of debt LEASE: Year 0 Year 1 Year 2 Year 3 Annual end-of-year lease payment (Net of tax) = $25,200* (1-0.40) $ 15,120.00 $ 15,120.00 $ 15,120.00 Purchase price at the end of year 3 $    5,000.00 Total cash outflows $                 -   $ 15,120.00 $ 15,120.00 $ 20,120.00 PVF (8%)          1.00000          0.92593          0.85734          0.79383 PV = Total Cash out flows * PVF $                 -   $ 14,000.00 $ 12,962.96 $ 15,971.90 Present value of cash outflows (Sum of PVs) $ 42,934.87 PURCHASE: Year 0 Year 1 Year 2 Year 3 Annual installment of loan (A) 25844 25844 25844 Annual service contract fees (Net of tax) = 1800 * (1-0.40) (B) 1080 1080 1080 Tax Saving on the depreciation MACRS Depreciation % 33.33% 44.45% 14.81% Cost $ 60,000.00 $ 60,000.00 $ 60,000.00 Depreciation $ 19,998.00 $ 26,670.00 $    8,886.00 Tax on depreciation = Dep * 40%(C) $    7,999.20 $ 10,668.00 $    3,554.40 Tax Saving on interest paid First year interest = 60000*14% = 8400 * 40% 3360 Second year interest = (60000+8400-25844)-*14% = 5957.84 * 40% 2383.14 Third year interest = (60000+8400-25844+5957.84 -25844)*14% = 3173.78 * 40% 1269.51 Saving on tax on interest (D) 3360 2383.14 1269.51 Net cash outflows (A +B -C -D ) $ 15,564.80 $ 13,872.86 $ 22,100.09 PVF (8%)          1.00000          0.92593          0.85734          0.79383 PV = Total Cash out flows * PVF $                 -   $ 14,411.85 $ 11,893.74 $ 17,543.76 Present value of cash outflows (Sum of PVs) $ 43,849.36 C. we can see that the PV of cash outflow for Lease option is lower than Purchase hence lease option is better

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