Your S Corporation needs a new truck for its operations and is looking at three

Question

Your S Corporation needs a new truck for its operations and is looking at three alternatives. The first alternative is to lease the truck for 60 months. The monthly lease payment is $525 per month with the first payment due in April. At the end of the lease, the truck will be returned to the dealer. The lease is considered an operating lease and excludes all maintenance and operational cost. The second alternative is to purchase the truck with a 60-month loan at an interest rate of 9% (APY 9.38). The loan has $250 in origination fees. The trucks entire sales price of $25,000- including the loan origination fees- can be financed. The first payment is due in April. The third alternative is to purchase the truck with cash for $25,000 in April. If your company purchases the truck, the estimated salavage value of the truck at the end of 5 years is $5000. Gains and losses on the sale of the truck will be treated as ordinary income. The truck may be depreciated using the half-year convention. For all three alternatives, the truck is to be placed in service in April. Your companys tax year is the same as the calendar year and its marginal tax rate 34%. Using the net present value (cost) method, which of the above alternatives is the best for your company if your MARR is 1% per month? Assume that there is sufficient taxable income to use all tax savings in the year they occur.

Explanation / Answer

Option 1 = Lease Payments less Taxshield on leases is the actual cash outlflow Lease Time 60 Months Lease Payment 525 Per month Per Annum Lease (Lease payment per month X no. of payments per annum = 525 * 12) Per Annum 6300 Per Annum For 60 Months 31500 $ Tax Rate 34% MARR (return required on capital) 12% (can be considered as discount factor for getting PV) Year 0 1 2 3 4 5 Per Annum Lease Outgo 6300 6300 6300 6300 6300 Tax Saving = Lease Payment * Tax Rate 2142 2142 2142 2142 2142 Cash Flow (since outflow negative) 0 -4158 -4158 -4158 -4158 -4158 PV Factor of 12% = 1/((1+12%)^n) 0.89285714 0.79719388 0.711780248 0.635518078 0.567426856 Present value of cash flows -3712.5 -3314.73214 -2959.58227 -2642.48417 -2359.36087 Total Cash outflow     (14,988.66) $ Option 2 = Deprecaition + emi payments less sum of taxshield and Salvage value is actual cash outflow APY 9.38% Truck Cost 25000 $ Original Fees 250 $ Tota Amount 25250 $ Loan Payment / EMI (for 5 yrs) ($3,593.97) $ Useful Life 5 years Salavage Value 5000 $ Depreciable Value 20000 $ Per Annum 4000 $ Year 0 1 2 3 4 5 Depreciation 4000 4000 4000 4000 4000 Interest Outgo 3593.97 3593.97 3593.97 3593.97 3593.97 Total Outgo 7593.97 7593.97 7593.97 7593.97 7593.97 Tax Shield (outgo X Tax Rate) {outgo saved} 2581.95 2581.95 2581.95 2581.95 2581.95 Salavge Value 5000.00 Net Cash Outflow (savings due to tax shield+Salvage Value) -5012.02 -5012.02 -5012.02 -5012.02 -12.02 PV Factor of 12% = 1/((1+12%)^n) 0.89285714 0.79719388 0.711780248 0.635518078 0.567426856 Present value of cash flows -4475.01555 -3995.5496 -3567.455 -3185.22768 -6.81900629 Total Cash Outflow     (15,230.07) $ Option 3 = Deprecaiaiton Less sum of Tax shield on deprectiaon and salvage value is cash outflow Buy with Cash 250000 $ Salavge vlaue 5000 $ Tax Rate 34% MARR 1% Assuming rate per annum' = 1% * 12 12% Year 0 1 2 3 4 5 Purchase Price -25000 Depreciation 4000 4000 4000 4000 4000 Tax Shield On Depreciation (outgo X tax rate) 1360 1360 1360 1360 1360 Salvage Value 5000.00 Net Cash Outflow (savings due to tax shield+Salvage Value) -2640 -2640 -2640 -2640 2360 PV Factor of 12% = 1/((1+12%)^n) 0.89285714 0.79719388 0.711780248 0.635518078 0.567426856 Present value of cash flows -25000 -2357.14286 -2104.59184 -1879.09985 -1677.76773 1339.127379 Total Cash Outflow     (31,679.47) $ Cost of Ownership via Loan     (15,230.07) Cost of Leasing     (14,988.66) Net advantage of leasing              241.41 $

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