Lease Versus Purchase Paper

Apr 18th, 2015
Steve1995
Category:
Business & Finance
Price: $20 USD

Question description

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
Year12345
Lease payments
Maintenance
Total tax-deductible expenses
Tax savings
After-tax net cash outflow from leasing

Cash Outflows/Inflows Associated with Owning
Year12345
Maintenance
Depreciation40,00060,00040,00030,00020,000
Interest20,00016,00012,0008,0004,000
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
Year123
Lease payments$55,00055,00055,000
Maintenance5,0006,0007,000
Total tax-deductible expenses60,00061,00062,000
Tax savings24,00024,40024,800
After-tax net cash outflow from leasing36,00036,60037,200

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
Year12345
Maintenance$ 5,0005,0005,000
Depreciation40,00060,00040,000Not applicable
Interest20,00016,00012,000Not applicable
Principal Repayment40,00040,00040,000 + 80,000 balance repaid = 120,000
Total tax-deductible expenses65,00081,00067,000
Tax savings26,00032,40026,800
Sale of equipment50,000
After-tax inflow from sale of equipment54,000
After-tax net cash outflow from owning39,00028,60056,200

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.

 

Tutor Answer

(Top Tutor) Daniel C.
(997)
School: Rice University
PREMIUM TUTOR

Studypool has helped 1,244,100 students

8 Reviews


Summary
Quality
Communication
On Time
Value
pmallory
Dec 5th, 2016
" Totally impressed with results!! :-) "
mixedballz
Nov 26th, 2016
" excellent work as always thanks for the help "
Five Star Tutor
Nov 23rd, 2016
" Outstanding Job!!!! "
kiln82
Nov 13th, 2016
" awesome work thanks "
darnay
Nov 4th, 2016
" The best tutor out there!!!! "
likeplum4
Oct 30th, 2016
" Excellent work as usual "
kpcutie
Oct 8th, 2016
" Excellent job "
Joemoe
Sep 29th, 2016
" <3 it, thanks for saving me time. "
Ask your homework questions. Receive quality answers!

Type your question here (or upload an image)

1827 tutors are online

Brown University





1271 Tutors

California Institute of Technology




2131 Tutors

Carnegie Mellon University




982 Tutors

Columbia University





1256 Tutors

Dartmouth University





2113 Tutors

Emory University





2279 Tutors

Harvard University





599 Tutors

Massachusetts Institute of Technology



2319 Tutors

New York University





1645 Tutors

Notre Dam University





1911 Tutors

Oklahoma University





2122 Tutors

Pennsylvania State University





932 Tutors

Princeton University





1211 Tutors

Stanford University





983 Tutors

University of California





1282 Tutors

Oxford University





123 Tutors

Yale University





2325 Tutors