Better Corp. has decided to purchase a new machine that costs $3.6 million. The
ID: 2803024 • Letter: B
Question
Better Corp. has decided to purchase a new machine that costs $3.6 million. The machine will be depreciated on a straight-line basis and can be sold for $500,000 before tax after four years. The corporate tax rate is 30 percent. The Sun Bank has offered Better a four-year loan for $3.6 million. The repayment schedule is four yearly principle repayments of $900,000 and an interest charge of 9 percent on the outstanding balance of the loan at the beginning of each year. Both principle repayments and interest are due at the end of each year. Can Do Leasing Corporation offers to lease the same machine to Better. Lease payments of $950,000 per year are due at the beginning of each of the four years of the lease.
a. What is the cost to Better if it purchased the equipment?
b. What is the cost to Better of leasing the equipment?
c. What is the NAL of leasing to Better?
d. Should Better lease the equipment from a financial perspective?
e. What is the maximum lease payment (pre tax) Better would be willing to pay?
Explanation / Answer
a. Cost to Better would be calculated as follows -
Year 1 : Outstanding principal is 3,600,000
Interest = 3,600,000*0.09 = 324,000
Total payment = 900,000 + 324,000 = 1,224,000
Year 2 : Outstanding principal is 2,700,000 (3,600,000 - 900,000)
Interest = 2,700,000*0.09 = 243,000
Total payment = 900,000 + 243,000 = 1,143,000
Year 3 : Outstanding principal is 1,800,000 (2,700,000 - 900,000)
Interest = 1,800,000*0.09 = 162,000
Total payment = 900,000 + 162,000 = 1,062,000
Year 4 : Outstanding principal is 900,000 (1,800,000 - 900,000)
Interest = 900,000*0.09 = 81,000
Total payment = 900,000 + 81,000 = 981,000
Income from sale of machine = 500,000 (1-tax rate) = 500,000 (1-0.3) = 350,000
Total Cost if equipment is purchased= 1,224,000 + 1,143,000 + 1,062,000 + 981,000 - 350,000 = 4,060,000
b) Total Cost if equipment is leased = 950,000 * 4 = 3,800,000
c) Net advantage of leasing = 4,060,000 - 3,800,000 = 260,000
d) Yes, Better should lease the equipment as it is more cost effective as compared to purchase (net NAL is positive)
e) Maximum lease payment would be amount that would make the NAL zero, i.e. there is no cost advantage in purchasing or leasing the equipment.
Max yearly lease payment = Total purchase cost/ no of years = 4,060,000/4 = 1,015,000
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