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 40%. Annual maintenance costs associated with ownership are estimated at $240,000, but this cost would be borne by the lessor if it leases. What is the net advantage to leasing (NAL), in thousands? (Suggestion: Delete 3 zeros from dollars and work in thousands.)

Please show all steps and calculations.

Answer 1

After Tax kD = r x (1 - t) = 10% x (1 - 0.40) = 6%

Depreciation per year = Cost / 3 = $4,800/3 = $1,600

Tax Saving from Depreciation = Dep. x t = $1,600 x 0.4 = $640

Lease Payment = $2,100

Salvage Value = $0

	0	1	2	3
Cost of Owning:
Interest		-480	-480	-480
Interest tax Saving		192	192	192
Maintenance		-240	-240	-240
Maintenance Tax Saving		96	96	96
Depre Tax Saving		640	640	640
Repayment of Loan				-4,800
Net Cash loan costs		208	208	-4,592
PV of Cost of Owning	-3,474
Cost of Leasing:
Lease Payment		-2,100	-2,100	-2,100
Tax Savings from lease		840	840	840
Net Cash Lease Costs		-1,260	-1,260	-1,260
PV Cost of Leasing (6%)	-3,368

NAL = PV Cost of Owning - PV Cost of Leasing = -3,474 - (-3,368) = -106