Question

Problem 21-7 Lease or Buy Super Sonics Entertainment is considering buying a machine that costs $600,000. The machine will be depreciated over five years by the straight-line method and will be worthless at that time. The company can lease the machine with year-end payments of $175,000. The company can issue bonds at an interest rate of 8 percent. The corporate tax rate is 40 percent. What is the NAL of the lease? (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) NAL $

Answer 1

Assume that discount rate is 10% p.a in both case

Buy option

Interest cost : 600000*8%

= 48000$

Net of tax interest cost =48000*.6

= 28800

Depreciation Amount = 600000/5

= 120000$

saving of tax on depreciation = 120000*.4

=48000$

Net cash flow of the year =48000-28800

=19200$

PVAF (10%, 5 Year) = 3.80

present value of annual cash flow =72960

Terminal Value

Repayment to bond holders 600000

Present value factor 0.621

present value 372600$

Net cost to company =372600-72960

=299640

Lease option

lease payment amount =175000

Tax benefit = 70000

Net annual out flow =105000

Present value factor 3.80

(10%, 5 Years)

Present value of annual cost = 399000

Ans 299640-399000

=-99360