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 $4,900,000, the purchase price, at 8% and buy the tools, or it can make 3 equal end-of-year lease payments of $2,050,000 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 30%. Annual maintenance costs associated with ownership are estimated at $220,000, 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.)

		$96
		$106
		$118
		$130
		$138

Answer 1

OPTION 1: PURCHASE OPTION

The loan amount is repayable with interest @ 8% in 3 equal annual installments at the end of each year.
The PVAF @8% for 3 years is 2.577
Therefore Annual Installment =  $4,900,000 / 2.577 = $1,901,364

We have to calculate the Interest cost for each year, for which we will first make a schedule of Debt Repayment which is attached below:

Note: Year 3 Interest is the Balancing figure.

Schedule of Debt Repayment (in thousand $) End of Total Payment Principal Year (Installment) Interest Principal Outstanding 4,900.00 1,901.44 392.00 1,509.44 3,390.56 1,901.44 271.25 1,630.19 1,760.37 1,901.44 141.06 1,760.37 (Bal. Fig.)

Now we will calculate the Present Value of Total Outflows from Purchase (Debt) Alternative, for which we will make a schedule of Cash Outflows as attached below:


Therefore, Total Present Value of Outflows under Debt/Purchase Option = $ 3,995.29 thousand

Note: While Discounting the Total Cash Outflow, we will use the after tax discounting rate, which is
8 * (1 - 0.3) = 8 * 0.7 = 5.6%


OPTION 2: LEASE OPTION

Lease Rent = $ 2,050 thousand
Tax Shield on above = 2,050,000 * 0.3 = $ 615 thousand

End of Year Annual Installment (a) 1,901.36 1,901.36 1,901.36 Schedule of Cash Outflows: Purchase/Debt Alternative in thousand $) Tax Shield Cash Outflows Interest Maintenance Cost Depreciation Total Cost (Total Cost * [(a+c) - Tax (b) (d) (b+c+d) 0.3) Shield)] 392.00 220.00 1,633.33 2,245.33 673.60 1,447.76 271.25 220.00 1,633.33 2,124.58 637.38 1,483.99 140.84 220.00 1,633.33 1,994.17 598.25 1,523.11 1 After Tax PV PV of Factor @ 5.6% Outflow 0.947 1,371.03 0.897 1,331.14 0.849 1,293.12 Total 3,995.29 3 Purchase Price 4,900.00 Residual value Useful Life Depreciation 1,633.33 Less: PV of Salvage Value PV of Outflows 3,995.29

Therefore, Annual Cash Outflow = 2,050 - 615 = $ 1,435 thousand
After Tax Cost of debt = 8 * (1 - 0.3) = 8 * 0.7 = 5.6%
PVAF @ 5.6% for 3 years = 2.693

Therefore, PV = $ 1,435 * 2.693 = $  3,864.34 thousand.
Therefore, Total Present Value of Outflows under Lease Option = $ 3,864.34 thousand

Therefore, NAL = $ 3,995.29 thousand - $ 3,864.34 thousand
= $ 130.95 thousands

Therefore, correct alternative from the given options is $ 130

Note : Ignore 0.95 as rounding off error