Question

To finance some manufacturing tools it needs for the next 3 years, Waldrop Corporation is considering a leasing arrangement. The tools will be obsolete and worthless after 3 years. The firm will depreciate the cost of the tools on a straight-line basis over their 3-year life. It can borrow $4,800,000, the purchase price, at 10% and buy the tools, or it can make 3 equal end-of-year lease payments of $2,100,000 each and lease them. The loan obtained from the bank is a 3-year simple interest loan, with interest paid at the end of the year. The firm's tax rate is 35%. Annual end-of-year maintenance costs associated with ownership are estimated at $240,000, but this cost would be borne by the lessor if it leases. If the lease is a guideline lease, what is the cost of owning?

	A.	-$2,575,868
	B.	-$4,800,000
	C.	-$3,730,000
	D.	-$3,368,000
	E.	-$3,474,000

Answer 1

Answer: C. - 3,730,000

Equipment Cost = $4,800,000
Interest rate =10%
Tax Rate =35%
After Tax cost of Debt = 10% x(1-0.35) = 6.5%
Deprecation per year = $4,800,000/3 = $1,600,000
Tax Saving on deprecation = $1,600,000 X 35% = $560,000
Annual Maintenance cost = $240,000
Cost of owning
Year	0	1	2	3
Interest		-480,000	-480,000	-480,000
Tax Saving on Interest		168000	168,000	168,000
Maintenance		-240000	-240,000	-240,000
Tax Saving on Maintenance		84000	84,000	84,000
Tax Saving on deprecation		560000	560,000	560,000
Repayment of loan				-4,800,000
Net cash loan costs		92,000	92,000	-4,708,000
PV of cash flows @6.5%	-3,730,016	86,385	81,113	-3,897,514
(1/(1+r)^n)
Cost of owning = $3,730,016 ~ 3,730,000