Question

Suppose Proctor? & Gamble? (P&G) is considering purchasing $15 million in new manufacturing equipment. If it purchases the? equipment, it will depreciate it for tax purposes on a? straight-line basis over five? years, after which the equipment will be worthless. It will also be responsible for maintenance expenses of $1.00 million per?year, paid in each of years 1 through 5. It can also lease the equipment under a true tax lease for $3.9 million per year for the five? years, in which case the lessor will provide necessary maintenance. Assume? P&G's tax rate is 35 % 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 rate that ?is, what lease amount could? P&G pay each year and be indifferent between leasing and financing a? purchase?

Dont round until the last step

Answer 1

a.Relevant Discount rate = kd(1-t)

=7.5(1-.35) = 4.875%

PV of Outflows under Leasing = 3.9(1-0.35)*PVAF(4.875%,5 yrs)

=2.535*4.344 = 11.01204 million

PV of Outflows under Loan = Amount of Loan – Present Value of Tax Savings on Depreciation + Present Vaue of Maintenance Cost net of tax

= 15- 1.05*PVAF(4.875%,5 yrs)+1(1-.35) *PVAF(4.875%,5 yrs)

=15 – 0.4*4.344 = 13.2624 million

Hence, leasing is better

Working note:

Depreciation each year = 15/5 = 3

Tax savings = 3*0.35 = 1.05

b.For indifference between leasing and purchasing

PV of Cash Outflow under loan = PV of Cash Outflow under Leasing

13.2624 = Annual Lease Payment(1-0.35)*4.344

Therefore, Annual Lease Payment = 4.69698 million