Tiffany\'s is considering the purchase of a new machine for $30,000 that has a 5

Question

Tiffany's is considering the purchase of a new machine for $30,000 that has a 5-year life and would be depreciated on a straight-line basis to a zero salvage value over its life. The machine is expected to save the firm $12,500 per year in operating costs. There is no actual salvage value. Alternatively, the firm can lease the machine for $7,300 annually for 5 years, with the first payment due at the end of the first year. The firm's tax rate is 34 percent and its cost of debt is 10 percent. What is the net advantage to leasing for the lessee?

-$1,134.40

$1,577.10

$1,602.15

-$1,408.16

$0

Explanation / Answer

Discount rate = post tax cost of debt = 10 x(1-0.34) 6.6 (i) Cost of leasing - Year Lease payments Tax savings on leaase Post tax lease PV factors PV 1 7300 2482 4818 0.938086 4519.6998 2 7300 2482 4818 0.880006 4239.8685 3 7300 2482 4818 0.825521 3977.3626 4 7300 2482 4818 0.77441 3731.1093 5 7300 2482 4818 0.726464 3500.1026 19968.143 (ii) Cost of buying - Loan repayment schedule - Year Beginning balance Installments Interest Principle Ending balance Interest tax savings(Intt. Tax rate) Depreciation tax savings (NOTE) Net outflow (Installments + maintainance cost - DTS - ITS) PV factors @ 5.4% PV of net cash flows 1 30000 7913.92 3000 4913.92 25086.08 1020 2040 4853.92 0.938086 4553.4 2 25086.08 7913.92 2508.608 5405.32 19680.76 852.9266 2040 5021.00 0.880006 4418.508 3 19680.76 7913.92 1968.076 5945.85 13734.91 669.1458 2040 5204.78 0.825521 4296.657 4 13734.91 7913.92 1373.491 6540.43 7194.48 466.9869 2040 5406.94 0.77441 4187.189 5 7194.48 7913.92 719.4477 7194.48 0.00 244.6122 2040 5629.31 0.726464 4089.492 21545.24 Net Advantage of leasing = Cost of buying - 21545.24 Less Cost of leasing - 19968.14 Answer is   B 1577.102 NOTES - Equipmemt cost 30000 Depreciation tax savings - Annual Depreciation 30000/5 6000 Tax savings on depreciation 30000 x 0.34 2040 Installments Cost of machine/Annuity factor(10%,5) Or use PMT function in excel Please provide feedback…. Thanks in advance…. :-)

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