Suppose a company wants to decide whether to lease or purchase an asset. Purchas

Question

Suppose a company wants to decide whether to lease or purchase an asset.

Purchase: The capital cost required to purchase the asset is $1,000,000 (at time zero) with a salvage value of $500,000 at the end of the 5th year. The purchased asset can be depreciated based on MACRS 5-year life depreciation with the half year convention (table A-1 at IRS) over six years (from year 0 to year 5).

Lease: The asset can be leased for 5 years and annual lease payments (LP) of $250,000 (from year 1 to year 5).

The asset would yield the annual revenue of $350,000 for five years (from year 1 to year 5) and operating cost of $60,000 for year 1 to 5.

Considering income tax of 40% and minimum ROR of 12%, calculate the ATCF and NPV for both alternatives and conclude which alternative is a better decision.

Explanation / Answer

VALUE DEP. RATE DEP AMOUNT 1 1000000 20% 200000 2 1000000 32% 320000 3 1000000 19.20% 192000 4 1000000 11.52% 115200 5 1000000 11.52% 115200 5.76% CASH OUTFLOW 1000000.00% cash inflow operating cash flow PROFIT BEFORE DEPRECIATION DEP PROFIT AFTER DEP TAX@40% AFTER TAX PROFIT dep profit after tax before dep. present value @12% present value of cash flow 1 350000 60000 290000 200000 90000 36000 54000 200000 254000 0.892857 226785.7 2 350000 60000 290000 320000 -30000 0 0 320000 320000 0.797194 255102 3 350000 60000 290000 192000 98000 39200 58800 192000 250800 0.71178 178514.5 4 350000 60000 290000 115200 174800 69920 104880 115200 220080 0.635518 139864.8 5 350000 60000 290000 115200 174800 69920 104880 115200 220080 0.567427 124879.3 500000 0.567427 283713.4 Year cash inflow operating cash flow lease payment profit present value @12% present value of profit PRESENT VALUE OF CASH FLOW 1208860 1 350000 60000 250000 40000 0.892857143 35714.29 Cash outflow 1000000 2 350000 60000 250000 40000 0.797193878 31887.76 NPV 208859.8 3 350000 60000 250000 40000 0.711780248 28471.21 4 350000 60000 250000 40000 0.635518078 25420.72 5 350000 60000 250000 40000 0.567426856 22697.07 sum of present value of profit or NPV 144191 NPV OF PURCHASE OF MACHINE IS HIGHER SO MACHINE SHOULD BE PURCHASED INSTEAD OG BUYING

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