Current assets, $300 Debt $400, Net fixed assets $500, Equity $400, Total assets

Question

Current assets, $300 Debt $400, Net fixed assets $500, Equity $400, Total assets $800 and Total claims $800. Assume Reynolds tax rate is 40% and the equipment depreciation would be $100 per year. If the company leased assets on a 2- year lease, the payment would be $110 at the beginning of each year. If Reynolds borrowed and brought, the bank would charge 10% interest on the loan. In either case, the equipment is worth nothing after 2 years and will be discarded. Should Reynolds lease or buy the equipment? Use flotation cost, interest, call premium, refunding tools and minimize the cost of capital as an example.

Explanation / Answer

The cost of owning or leasing is the present value of cash flows. The discounting rate is the after tax cost of debt. The discounting rate is 10%X(1-0.4) = 6% Cost of Leasing - The payments are $110 per year payable at the beginning. The cash flow is the after tax cost. The after tax cost is 110X(1-0.4) = $66. Since the payments are beginning of the year, 1st payment is now and second is at the beginning of year 2 or end of year 1. The PV is $66 for payment now + 66/1.06 for payment end of year 1 = 66+62 = $128 The total cost is -$128 since it is an outflow. Cost of Owning - Since the depreciation is 100 per year, the cost of the asset is $200. Depreciation will give depreciation tax shield, which is 100X40%=$40 per year at the end of each year. The PV of depreciation tax shield is 40/1.06 + 40/1.06^2 = $73 The outflow is -$200 for purchase and inflow is depreciation benefit is $73 The cost of owning = -200+73 = -$127 Reynolds should buy the equipment as the cost is lower Found it from here: http://www.justanswer.com/finance/20r0q-assume-reynold-s-tax-rate-40-equipment-s-depreciation.html

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