Question

Suppose Procter and Gamble​ (P&G) is considering purchasing $ 11 million in new manufacturing equipment. If it purchases the​ equipment, it will depreciate it on a​ straight-line basis over the five​ years, after which the equipment will be worthless. It will also be responsible for maintenance expenses of $ 1.50 million per year.​ Alternatively, it can lease the equipment for  $ 2.5 million per year for the five​ years, in which case the lessor will provide necessary maintenance. Assume​ P&G?s tax rate is 40 % and its borrowing cost is 7.5 %.

a. What is the NPV associated with leasing the equipment versus financing it with the lease equivalent​ loan?

b. What is the​ break-even lease ratelong dashthat ​is, what lease amount could​ P&G pay each year and be indifferent between leasing and financing a​ purchase?

Answer 1

a]	Discount rate = 7.5%*(1-40%) =	4.50%
	BUYING WITH LOAN:
	NPV of buying = -Cost of the asset+PV of depreciation tax shield-PV of after tax maintenance cost = -11000000+(11000000/5)*40%*PVIFA(4.5,5)-1500000*60%*PVIFA(4.5,5)
	= -11000000+(11000000/5)*0.4*4.38998-1500000*0.6*4.38998 =	$ -1,10,87,800
	LEASING:
	NPV of leasing = -2500000*(1-40%)*4.38998 =	$ -65,84,970
	NAL OF LEASING:
	NAL of leasing = NPV of leasing-NPV of buying	$          45,02,830
b]	Break even lease rental after tax = 11087800/4.38998 =	$          25,25,706
	Break even lease rental [before tax shield] = 2525706/60% =	$          42,09,510