Lease Versus Purchase Paper

Using the problem and answer highlight in yellow answer this question:

  • Discuss the application of time value of money concepts used in evaluating lease versus purchase decisions

 

Management has decided to acquire a new asset that costs $200,000. The estimated economic life of the asset is five years, but the firm wants the use of the asset only for three years. If the firm purchases the asset, it anticipates selling it at the end of three years for $50,000.

The firm may lease the asset for $55,000 a year paid at the end of each year. The lease does not include maintenance. It is estimated that annual maintenance initially will be $5,000 (paid at the end of the year), but that cost will increase by $1,000 each year as the asset ages.

The firm could purchase the asset with a five-year loan of $200,000. The loan will be retired in five payments of $40,000 unless the equipment is sold, in which case the loan must be paid off at closing of the sale. The interest rate is 10 percent and is paid at the end of each year on the balance owed. The annual interest payment is provided below.

If the firm does purchase the asset, it will enter into a maintenance agreement with the manufacturer that costs $5,000 a year. The annual depreciation expense is provided below. The firm’s tax bracket is 40 percent.

Based on the above information, should the firm borrow and purchase or should the firm lease?

To help answer the question, fill in the following tables. (It is not necessary to have an entry in every blank.)

Cash Outflows/Inflows Associated with Leasing
Year 1 2 3 4 5
Lease payments
Maintenance
Total tax-deductible expenses
Tax savings
After-tax net cash outflow from leasing

Cash Outflows/Inflows Associated with Owning
Year 1 2 3 4 5
Maintenance
Depreciation 40,000 60,000 40,000 30,000 20,000
Interest 20,000 16,000 12,000 8,000 4,000
Principal Repayment
Total tax-deductible expences
Tax savings
Sale of equipment
After-tax inflow from sale of equipment
After-tax net cash outflow from owning

Answer

A1:

Since the present value of the cash outflows from owning exceed the present value of the cash outflows from leasing, leasing is preferred.

Cash Outflows/Inflows Associated with Leasing
Year 1 2 3
Lease payments $55,000 55,000 55,000
Maintenance 5,000 6,000 7,000
Total tax-deductible expenses 60,000 61,000 62,000
Tax savings 24,000 24,400 24,800
After-tax net cash outflow from leasing 36,000 36,600 37,200

Present value of the cost of leasing (using the 10 percent interest rate):

$36,000(0.909) + $36,600(0.826) + $37,200(0.751) = $90,892

Cash Outflows/Inflows Associated with Owning
Year 1 2 3 4 5
Maintenance $ 5,000 5,000 5,000
Depreciation 40,000 60,000 40,000 Not applicable
Interest 20,000 16,000 12,000 Not applicable
Principal Repayment 40,000 40,000 40,000 + 80,000 balance repaid = 120,000
Total tax-deductible expenses 65,000 81,000 67,000
Tax savings 26,000 32,400 26,800
Sale of equipment 50,000
After-tax inflow from sale of equipment 54,000
After-tax net cash outflow from owning 39,000 28,600 56,200

Present value of the cost of leasing (using the 10 percent interest rate):

$39,000(0.909) + 28,600(0.826) + 56,200(0.751) = $101,281

Since the asset is sold at the end of the third year, there are no entries for years 4 and 5 even though the expected life of the asset is five years.

The $80,000 balance of the loan must be repaid when the asset is sold.

The asset is sold for $50,000 but its book value is $60,000. The book value is the $200,000 cost minus the sum of the amount of depreciation during the first three years ($40,000 + $60,000 + $40,000). Since the asset is sold for $50,000, the firm has a $10,000 loss ($50,000 – $60,000). The $10,000 loss produces a $4,000 tax savings ($10,000 × 0.4). The net cash inflow from the sale is $50,000 + $4,000 = $54,000.

The cash outflow at the end of the third year is maintenance ($5,000) plus interest ($12,000) plus principal repayment ($120,000) minus the tax savings ($26,800) plus the after-tax proceeds from the sale ($54,000). That is $5,000 + $12,000 + $120,000 – $26,800 – $54,000 = $56,200.

 

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