Question

Suppose Clorox can lease a new computer data processing system for 971,000 per year for five years. Alternately it can purchase the system for 4.22 million. Assume Clorox has a borrowing cost of 6.7% and a tax rate of 35% and the system will be obsolete at the end of two years.

A. If Clorox will depreciate the computer equipment on a straight line basis over the next five years, and if the lease qualifies a true tax lease qualifies as a true tax lease. Is it better to lease or finance the purchase of the equipment?

B. Suppose that if Clorox buys the equipment, it will use accelerated depreciation for tax purposes. Specifically, suppose it can expense 20% of the purchase price immediately and can take depreciation equal to 32%, 19.2%, 11.5%, 11.52% and 5.76% of the purchase price over the next five years. Compare leasing with purchase in this lease.

C. If Clorox buys the equipment it will pay 4.22 million upfront and have depreciation expenses of ____ per year, and generating a depreciation tax shield of____per year for years 1-5

Please if you can break this down step by step, and also this question has 12 parts. Thank You

Answer 1

Sol A: True Tax lease basically means that the Lessee in our Case Clorox can take benefit for Tax Purposes of Lease Rent expense only. The Lessor can take benefit of Depreciation for Tax Purposes. Thus, while comparing leasing with buying option in this case. The Basic outflows in Leasing will be Lease Rent and the only inflow will be Tax Saving on Lease Rent expense i.e. 35% of Lease Rental (971000*0.35=339850). The purchase option on the other hand will have an initial outflow of 4.22 mn and a Net Interest (6.70%(1-0.35)=4.36% of Purchase Cost. The inflows will be depreciation as it is a non cash expense and Tax Savings of 35% of Depreciation Expense. This will then enable us to compare both the options in which Buying Option is the Benifiticial Option for Clorox. The Cash Flows are as under:

Time	Type	Cash Flow Leasing	Cash Flow Purchase
0	Purchase	0	-4220000
1	Lease Rent	-971000	0
1	Depreciation		844000
1	Interest Cost	0	-183781
1	Tax Shield	339850	295400
2	Lease Rent	-971000	0
2	Depreciation	0	844000
2	Interest Cost	0	-183781
2	Tax Shield	339850	295400
3	Lease Rent	-971000	0
3	Depreciation	0	844000
3	Interest Cost	0	-183781
3	Tax Shield	339850	295400
4	Lease Rent	-971000	0
4	Depreciation	0	844000
4	Interest Cost	0	-183781
4	Tax Shield	339850	295400
5	Lease Rent	-971000	0
5	Depreciation	0	844000
5	Interest Cost	0	-183781
5	Tax Shield	339850	295400
	Total Cost	-3155750	558095

Sol B. The question should have been as non tax lease as with true tax lease the benefit of depreciation is going to the lessor and not to Clorox who is Lessee. Thus the Cash flow calculations are given below and we have left the interest cost delebritely so to just see what impact that accelerated Depreciation has on Buying the Process. It is having a positive impact calculated as under:-

Time	Type	Cash Flows Leasing	Cash Flows Buying		W No 1
0	Buying	0	-4220000		Depreciation Schedule
0	Dep @ 20%	0	844000		Buying Cost	4220000
0	Tax Shield	0	295400		Time 0 @ 20%	-844000
1	Lease Rent	-971000	0		Balance at end of Year 0	3376000
1	Dep @ 32%	0	1350400		Time 1 @ 32%	-1350400
1	Tax Shield	339850	472640		Balance at the end of Year 1	2025600
1	Lease Rent	-971000	0		Time 2 @ 19.2%	-810240
1	Dep @ 19.2%	0	810240		Balance at the end of Year 2	1215360
1	Tax Shield	339850	283584		Time 3 @ 11.5%	-485300
1	Lease Rent	-971000	0		Balance at the end of Year 3	730060
1	Dep @ 11.50%	0	485300		Time 4 @ 11.52%	-486144
1	Tax Shield	339850	169855		Balance at the end of Year 4	243916
1	Lease Rent	-971000	0		Time 5 @ 5.76%	-243072
1	Dep @ 11.52%	0	486144		Balance at the end of Year 5	844
1	Tax Shield	339850	170150.4
1	Lease Rent	-971000	0
1	Dep @ 5.76%	0	243072
1	Tax Shield	339850	85075.2
	Total Cost	-3155750	1475860.6

Sol C. Depreciation Expenses on Straight Line basis is 844000 per year and Depreciation Tax Shield is 35% of this expense as 295400. The calculation is as under:

W No 1	Depreciation
Cost of Purchase	4220000
Term Years	5
SLM	844000	Dep / Year
W No 2	Tax Shield		Tax (No Dep / Int)
Suppose PBDIT	1000000		1000000
Depreciation	844000		0
Interest	0		0
PBT	156000		1000000
Tax @ 35%	54600		350000
Thus Tax Shield	295400	or 35% of Depreciation