Question

The GO PRO Company is planning to launch a new product line. The equipment needed to produce the new cameras will cost $1 million, with a lifetime of five years, and no salvage value. The company's tax rate is 40%, and the equipment would be depreciated using straight-line depreciation over five years. Alternatively, the company could rent the equipment instead, for five years, at a cost of $250,000 per year, payable at the end of each year.

(a)     If the company decides to rent the equipment, what would be the after-tax cost of the money made available by renting? (Hint: This is the incremental rate of return corresponding to the difference between renting and buying. Remember that rented equipment cannot be depreciated, but rental payments are tax-deductible.)

(b)     Now revise your answer to part (a) above to reflect the assumption that the rental payments will inflate by 10% per year (i.e., starting at $275,000 in year 1). Explain.

Answer 1

a. Option 1 : If the company decides to buy the machine, the initial cost will be $1 million.

Depreciation on the machine per year = $1,000,000 /5 = $200,000

Tax savings on depreciation = $200,000 * 40% = $80,000

Option 2 : Lease payment for year = $250,000

Since no tax shield is available on rented machinery, savings are available on rental payments.

After tax cost of rent = $250,000 - (250,000 *40%) = $ 150,000

b. Inflation per year = 10%

Let the rental payment for each be R.

If the rent in year 1 is 275,000 , rent in year 2 will be 302,500 [ 275,000 *1.1] and so forth.

After tax cost of rent each year with inflation = 1.1 * R_t-1 * (1-.04) = 0.66 R_t-1