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?

Explanation / Answer

Ans.:) i bit

Working Note : 2) Calculation of loan Instalment amount

Instalment amount * Present Value annuity factor for 5 Years @ 11 % = Loan Amount

Instalment amount = 1000000/3.695897 =2,70,570 per year

Total Cash outflow with purchase option = 127744+94419+163555+173215+181174 = 740106 $

(*) Discounting Factor = 11%- tax effect = 11- (11*30%) = 7.7%

Working Note : 5) Present value factors calculations

Ans.:) ii bit

Ans.:) iii bit

Net advantage from leasing the equipment than purchase = 740106 - 647941 = 92,165 $

It is advisable to leasing equipment than the taking loan & purchase the equipment because leasing the equipment has lesser outflow when compared to purchase the equipment.

Note : I assumed that loan repayment is equated annual instalments because in this problem repayment schedule was not given.

Working Note : 1 (Calculation of Depreciation) Year Depretiation Rate Depreciation 1 33.33% 333300 2 44.45% 444500 3 14.81% 148100 4 7.41% 74100 Total Depreciation 1000000 So writtendown value = 1000000-1000000 = 0

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