Walton Nursing Home (WNH) is evaluating a guideline lease agreement on laundry e

Question

Walton Nursing Home (WNH) is evaluating a guideline lease agreement on laundry equipment that costs $250,000 and falls into the MACRS three-year class. The home can borrow at an 8 percent rate on a four-year loan if WHN decided to borrow and buy rather than lease. The laundry equipment has a four-year economic life, and its estimated residual value is $50,000 at the end of Year 4. If WHN buys the equipment, it would purchase a maintenance contract which costs $5,000 per year, payable at the beginning of each year. The lease terms, which include maintenance, call for a $71,000 lease payment at the beginning of each year. WNH's tax rate is 40 percent. Should the home lease or buy?

Explanation / Answer

Before Tax Cost of Debt 8.00% MACRS Tax Rate 40.00% Year 1 2 3 4 After Tax Cost of Debt 4.80% 33.00% 45.00% 15.00% 7.00% Lease payment -$71,000.00 System purchase price -$250,000.00 Annual Maintenance -$5,000.00 Residual value $50,000.00 Cost of owning: Year 0 1 2 3 4 Net purchase price -$250,000.00 Annual Maintenance -$5,000.00 -$5,000.00 -$5,000.00 -$5,000.00 Maintenance tax savings (Annual Maintenance x 40%) 2000 2000 2000 2000 Depreciation tax saving (Machine cost x MACRS x 40%) 33000 45000 15000 7000 Residual value $50,000.00 Tax on residual value -$20,000.00 Net cash flow -$253,000.00 $30,000.00 $42,000.00 $12,000.00 $37,000.00 PV @ 4.8% $1.00 $0.95 $0.91 $0.87 $0.83 -$253,000.00 $28,625.95 $38,240.78 $10,425.51 $30,673.02 PV cost of owning -$145,034.73 Cost of Leasing 0 1 2 3 4 Lease payment -$71,000.00 -$71,000.00 -$71,000.00 -$71,000.00 Lease tax savings $28,400.00 $28,400.00 $28,400.00 $28,400.00 Net cash flow -$42,600.00 -$42,600.00 -$42,600.00 -$42,600.00 PV @ 4.8% $1.00 $0.95 $0.91 $0.87 -$42,600.00 -$40,648.85 -$38,787.08 -$37,010.57 $0.00 PV cost of leasing -$159,046.50 Net advantage to leasing PV cost of leasing -$159,046.50 PV cost of owning -$145,034.73 NAL -$14,011.77 The PV of the cost of leasing is greater than the PV of the cost of owning. Therefore, WHN should buy the equipment.

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