Question

Cayman Productions is considering either leasing or buying some new underwater photographic equipment. The lessor charges $26,900 a year for a 2-year lease, starting year 1. The purchase price is $48,600. The equipment has a 2-year life after which time it will be worthless. Cayman uses straight-line depreciation, borrows money at 8 percent, and has sufficient tax loss carryovers to offset any taxes which otherwise might be owed for the next 4 years. What is the NPV of the lease? (You don’t have to use the table if you don’t find it helpful). (a) -$1,315 (b) -$1,298 (c) $630 (d) $1,343 (e) $1,457

Answer 1

As there are sufficient tax loss carryovers to offset any taxes, the effective tax rate is zero.

NPV of leasing is the NPV of the lease relative to the purchase.

This is calculated by calculating the present value of the advantage each year.

Advantage each year = Cash flow with leasing - cash flow with buying.

Buying :

Cash outflow in year 0 = cost of equipment.

Leasing :

Net cash outflow with leasing = lease payment

NPV of leasing vs buying

Advantage each year = Cash flow with leasing - cash flow with buying.

Present value factor (discount factor) each year = 1 / (1 + discount rate)^year.

Discount rate = after-tax cost of borrowing = 8%.

Net Advantage of leasing each year = advantage amount * discount factor.

NPV of the lease relative to the purchase = $630

The answer is (c)