Question

AP fusion has decided to acquire a cooling machine. Its cost is $50,000. In five years it can be salvaged for $15,000. The Cloister Bank has agreed to advance funds for the entire purchase price at 8 percent per annum payable in equal installments at the end of each year over the five years. As an alternative, the machine could be leased over the five years from the manufacturer, Peterbuilt., with annual lease payments of $10,000 payable at the beginning of each year. Ap tax rate is 20 percent. Its cost of capital is 15 percent, and its tax shields are realized at the end of the year. Cooling machines have a CCA rate of 20 percent. If the machine is owned, annual maintenance costs will be $500. Calculate PV cost of lease alternative, Calculate PV cost of borrowing/ purchase alternative and state which one you belive is the best option for AP to go with.

Answer 1

AP fusion

n = 5 T = 20% k = 15% d = 20%

Discount rate (r or i) = 8% (1 – .20) = 6.4%

Lease alternative

Annual lease payment BGN(in advance)

$10,000 @ PV_IFA (n = 5, %i = 6.4%) $(44,336)

Tax savings on annual lease payment (in arrears)

$10,000 × 20% @ PV_IFA (n = 5, %i = 6.4%)   8,334

PV cost of lease alternative $(36,002)

Borrowing alternative

PV of annual loan payments and tax savings

from interest expense (cost of machine) $(50,000)

Salvage value $15,000 @ PV_IF (n = 5, k = 15%) 7,458

PV of annual maintenance payments

$500 × (1 – .20) @ PV_IFA (n = 5, %i = 6.4%) (1,667)

PV cost of borrowing/ purchase alternative $(37,554)

NPV of lease alternative (relative to borrowing) $ 1,552

AP fusion should lease as the NPV is positive.