Suppose BETA (a multinational manufacturer and marketer of consumer and professi
ID: 2649736 • Letter: S
Question
Suppose BETA (a multinational manufacturer and marketer of consumer and professional products) can lease a new computer data processing system for $975,000 per year for five years under an operating lease. Alternatively, it can purchase the system for $4.25 million. Assume BETA has a borrowing cost of 7% and a tax rate of 35%, and the system will be obsolete at the end of five years.
A) If BETA will depreciate (for tax purposes) the computer equipment on a straight-line basis over the next five years, and if the operating lease qualifies as a true tax lease, is it better to finance the purchase of the equipment or to lease it?
B) Suppose that if BETA buys the equipment, it will use accelerated depreciation for tax purposes. Specifically, the CCA rate will be 45% and any undepreciated capital cost (UCC) in year 6 will be taken as a terminal loss. Compare leasing with purchase in this case.
Show your reasoning and calculations.
Explanation / Answer
A)If computer data processing is taken on lease: [since tax shield is availabke on lease rentals therefore lease rentals are taken after tax]
since borrowing cost is taken as discounting rate therefore tax shield is available on it = 7(1-.35) = 4.55%
Present value of lease rentals of 5 years= PVAF @4.55%,5years *Lease rentals after tax
= 4.38387 *[975000(1-.35)]
=4.38387* 633750
= $ 2,778,275.60
If computer data processing system is purchased.:If it will purchased it will taken on loan.
so Loan installment per year = PVAF@7%,5years * Loan installment =Purchase cost
= 4.10020 * X= 4,250,000
X(Loan installment)= 4250000/4.10020
= $ 1,036,534.80
Loan repayment schedule
Present value of cost If computer is purchased:
**Depreciation = 4250000/5 = $850000
**Tax sheild on depreciation= 850000*35% -=297500
Total lease cost = $ 2,778,275.60
Total Purchase cost = $ 2,945,815.66
Since total lease cost is lower than total purchase cost therefore company should take asset on lease.
B)If Accelerated depreciation method is used , depreciation schedule is as follows.
Terminal loss= 213895.86
Tax shield on loss =213895.86*35%=$ 74863.55
Total lease cost =$2,778,275.60
Total purchase cost= $2,893,592.47
The company shall go for leasing as total cost is less than purchasing
Opening balance of loan(A) Installment(B) Interst(paid on opening balance)(C) principal amountD=(B-C) loan balance at end(A-D) 4250000 1036534.80 297500 739034.80 3510965.20 3510965.20 1036534.80 245767.56 790767.24 2720197.96 2720197.96 1036534.80 190413.86 846120.94 1874077.02 1874077.02 1036534.80 131185.39 905349.41 968727.61 968727.61 1036534.80 67814.67 968727.61 0Related Questions
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