Reynolds Imaging needs a piece of diagnostic equipment that costs $200 thousand.
ID: 2772408 • Letter: R
Question
Reynolds Imaging needs a piece of diagnostic equipment that costs $200 thousand. Reynolds can either lease the equipment or borrow $200 thousand from a local bank and buy the equipment. Reynolds tax rate is 40 percent and the equipment depreciation would be $100 thousand per year. If the company leased the asset on a 2-year lease, the payment would be $110 thousand at the beginning of each year. If Reynolds borrowed and bought, the bank would charge 10 percent interest on the loan.
What is the NAL? Should Reynolds buy or lease the equipment?
Explanation / Answer
Given
Cost of Equipment = $ 200,000
Time Period = 2 years
Cost of Borrowing = 10%
Tax Rate =40%
Depreciation = $ 100,000 per annum
Assuming 10% which is interest rate on borrowing as cost of capital
Option - Leasing of Equipment
Lease Rental = $ 110,000 payable at the beginning of the year
Present Value of Lease rental = $ 110,000 + $110,000/(1+0.10) = $ 110,000 + 110,000/1.1
= $ 110,000 + $ 100,000 = $ 210,000
Option – Buy the equipment
Initial Loan Amount = $ 200,000 (Taken as Loan from Bank)
Interest on Loan = $ 200,000 * 10% = $ 20,000
Depreciation = $ 100,000
Net cost flow = ($ 100,000 + $ 20,000)(1-0.40) = $ 120000 * 0.60 = $ 72,000
Net Liability on account of borrowing = Net cost flow / 1.10 + Net cost flow / 1.10^2 + Terminal Amount of Loan/1.10^2
= $ 72,000/1.10 + $ 72,000/1.10^2 + 200,000/1.10^2
= 65454.55 + 59,504.13 + 165289.25
= $ 290,247.93
Since the cost of taking the equipment is less compared to cost of borrowing, it is better to take the equipment on lease.
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