Question

Your firm has just sold non-strategic assets to raise cash for capital investment while avoiding the use of debt. The firm may buy a piece of machinery for $140,000 [with a useful or depreciable life of 4 years]. Your pretax cost of capital is 8% [and your tax rate is 20%]. You can lease the machine for $43,500 per year and the estimated salvage/recovery value at the end of four years [based on actual market data] is $20,000. Should you lease or buy? Explain by showing your work.

Answer 1

1. Calculation of Discount Rate:

Pre Tax Cost of Capital (1- Tax Rate)

= 8% (1-20%)

=6.4%

2. Calculation of tax saving on depreciation:

Annual Depreciation = Cost of Asset - Salvage Value

Useful Life

= 140,000 - 20000

4

= $ 30,000

Now annual tax saving on depreciation = Annual Depreciation * Tax Rate

= 30,000 * 20%

= $ 6,000

2. Evaluation from the point of Leasing:

Present Value of Cash Outflow = Annual Lease rent paid * PVIF @ 6.4%, 4 years

= $ 43,500 * 3.4336

= $ 149,362

3. Evaluation from the point of Purchasing

Present Value of Cash Outflow = Purchase Cost - Tax saving on depreciation * PVIF @ 6.4%, 4 years * Salvage value * PVF @ 6.4%, 4 years

= $ 140,000 - ($ 6000 * 3.4336) * ($20,000 * 0.7802)

= $ 119,398

Decision: Since the present value of cash outflow is more in case of leasing the machinery, firm should opt for buying decision.