Thomas Corporation is evaluating whether to lease or purchase equipment. Its tax

Question

Thomas Corporation is evaluating whether to lease or purchase equipment. Its tax rate is 30 percent. The company expects to use the equipment for 5 years, with no expected salvage value. The purchase price is $1 million and MACRS depreciation, 3-year class, will apply.       If the company enters into a 5-year lease, the lease payment is $230,000 per year, payable at the beginning of each year. If the company purchases the equipment it will borrow from its bank at an interest rate of 11 percent.

a. Calculate the cost of purchasing the equipment with debt.

b. Calculate the cost of leasing the equipment.

c. Calculate the net advantage to leasing. Should the company purchase or lease the equipment?

b. Calculate the cost of leasing the equipment.

c. Calculate the net advantage to leasing. Should the company purchase or lease the equipment?

Explanation / Answer

a) Cost of purchasing the equipment with debt --@ after-tax cost ie. 70% of 11% ie. 7.7% Year Details inflow/(outflow) Tax savings on interest MACRS Depn. Tax savings on depn. Net cash flow PV F @ 7.7% PV of net cash flow 0 Bank loan 1000000 1000000 1 1000000 0 Purchase of equipment -1000000 -1000000 1 -1000000 1 Interest expense -110000 33000 333300 99990 22990 0.92851 21346.445 2 -110000 33000 444500 133350 56350 0.86212 48580.462 3 -110000 33000 148100 44430 -32570 0.80048 -26071.63 4 -110000 33000 74100 22230 -54770 0.74325 -40707.8 5 -110000 33000 -77000 0.69012 -53139.24 5 Repayment of principal -1000000 -1000000 0.69012 -690120 PV of yearly cash flows -740111.8 Cost of purchasing= $740,112 b )Cost of leasing Year Details inflow/(outflow) Tax savings on interest Net cash flow PV F @ 7.7% PV of net cash flow 1 Lease payment -230000 69000 -161000 1 -161000 2 Lease payment -230000 69000 -161000 0.92851 -149490 3 Lease payment -230000 69000 -161000 0.86212 -138801 4 Lease payment -230000 69000 -161000 0.80048 -128877 5 Lease payment -230000 69000 -161000 0.74325 -119663 PV of lease payments -697832 Cost of leasing= $697,832 Note: Lease payment is at the beginning of the year. c) The net advantage to leasing Cost of purchasing $740,112 Cost of leasing $697,832 Net advantage of leasing $42,280 Suggestion : The company should lease as cost of leasing is less than the cost of purchasing the equipment

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