You work for a nuclear research laboratory that is contemplating leasing a diagn

Question

You work for a nuclear research laboratory that is contemplating leasing a diagnostic scanner (leasing is a common practice with expensive, high-tech equipment). The scanner costs $5,800,000, and it would be depreciated straight-line to zero over four years. Because of radiation contamination, it will actually be completely valueless in four years. You can lease it for $1,690,000 per year for four years.

1. Lease or Buy Assume that the tax rate is 35 percent. You can borrow at 8 percent before taxes. Should you lease or buy?

2. Leasing Cash Flows What are the cash flows from the lease from the lessor’s viewpoint? Assume a 35 percent tax bracket.

3. Finding the Break-Even Payment What would the lease payment have to be for both the lessor and the lessee to be indifferent about the lease?

Explanation / Answer

Hence its is better to lease

Leasing Cash Flows What are the cash flows from the lease from the lessor’s viewpoint? Assume a 35 percent tax bracket.

Finding the Break-Even Payment What would the lease payment have to be for both the lessor and the lessee to be indifferent about the lease?

To find the maximum lease payment that would satisfy both the lessor and the lessee, we need to find the payment that makes the NAL equal to zero. Using the NAL equation and solving for the OCF, we find:

NAL = 0 = $ 5,800,000 OCF(PVIFA8%,4)

OCF = $1,643,274.35

The OCF for this lease is composed of the depreciation tax shield cash flow, as well as the aftertax lease payment.

The depreciation tax shield is:

Depreciation tax shield = 507,500

Subtracting out the depreciation tax shield cash flow, we find:

After-tax lease payment = $1,643,274.35 507500 = $1,135,774.35

Since this is the after-tax lease payment, we can now calculate the break-even pretax lease payment as:

Break-even lease payment = $1,135,774.35/(1 0.35) = $1,747,345

Cash Flow For Buy options PF Factor 8%*(1-.35) =5.2% Intial Cost -5800000 1 -5800000 Tax Saving On Depreciation 5800000/4 years *.35 507500 3.5295 1791241 NPV -4008759

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