Question

Matric Number: Section: Question 2: (20 marks) You are evaluating a lease that offers annual payments of $17.000 for five years. Under this case you are responsible for maintenance and insurance, total cost of $2.500 per year. At the end of the lease you can purchase the asset for $5,000. All payments and expenses are paid at the end on the year. Alternatively, you can obtain a $60,000 five year loan to purchase the asset. This loan, calculated on a yearly reducing balance cost you 12%. Depreciation is on straight line over the 5-year useful life of the asset. Annual maintenance and insurance cost totalled $2,500, taxes are 40% and the discount rate is 10%. a) Which option should you choose? You are required to show the Net Advantage to Leasing [NAL] (17.5 marks) b) Identify the financial concepts that can be used to help make a lease versus purchase decision. (2.5 marks)

Answer 1

		PURCHASE OPTION
		Equipment Cost	$60,000
		5 year MACRS
		Equipment Cost=$190000	$60,000
			A=1/5	B=A*60000	D=B*40%
			Depreciation	Amount of	Depreciation
		Year	Rate	Depreciation	Tax Shield
		1	20.00%	$12,000	$4,800
		2	20.00%	$12,000	$4,800
		3	20.00%	$12,000	$4,800
		4	20.00%	$12,000	$4,800
		5	20.00%	$12,000	$4,800
		INTEREST AND PRINCIPAL REPAYMENT ON AMOUNT BORROWED
	Pv	Amount Borrowed =	$60,000
	Nper	Number of years of repayment	5
	Rate	Interest Rate	12%
	PMT	Annual repayment in five equal instalments	$16,645	(Using PMT function of excelwith Rate=12%,Nper=5, Pv=-60000
		REPAYMENT SCHEDULE
		Year		1	2	3	4	5
	A	Beginning Balance		$60,000	$50,555	$39,977	$28,130	$14,861
	B	Amount of annual payment		$16,645	$16,645	$16,645	$16,645	$16,645
	C=A*17%	Interest		$7,200	$6,067	$4,797	$3,376	$1,783
	D=B-C	Principal		$9,445	$10,578	$11,847	$13,269	$14,861
	E=A-D	Ending Balance		$50,555	$39,977	$28,130	$14,861	$0
		After tax maintenance and insurance Cost	$1,500	(2500*(1-0.4)
		Present Value of Cash Flow=(Cash Flow)/((1+i)^N)
		i=discount rate =10%
		N=Year of cash flow
	N	Year	0	1	2	3	4	5
		Annual Cash Inflows:
	.(1)	After tax maintenance and insurance Cost		-$1,500	-$1,500	-$1,500	-$1,500	-$1,500
	C	Annual Interest Payment		$7,200	$6,067	$4,797	$3,376	$1,783
	,(2)=C*(1-0.4)	After Tax Interest Cost for amount borrowed		-$4,320	-$3,640	-$2,878	-$2,025	-$1,070
	.(3)	Depreciation Tax shield		$4,800	$4,800	$4,800	$4,800	$4,800
	.(4)	Payment of Principal		-$9,445	-$10,578	-$11,847	-$13,269	-$14,861
	CF=(1)+(2)+(3)+(4)	Total Cash Flow		-$10,465	-$10,918	-$11,426	-$11,994	-$12,631	SUM
	PV=CF/(1.1^N)	Present Value of Cash Flow		-$9,513	-$9,023	-$8,584	-$8,192	-$7,843	-$43,156
		NET PRESENT VALUE(NPV) of COSTS OF PURCHASE	$43,156
										LEASE OPTION After tax lease payment =17000*(1-0.6) $10,200.00 $1,500 (2500*(1-0.4) After tax maintenance and insurance Cost Year 2 3 4 (1) After Tax Lease Payment -$10,200 -$10,200 -$10,200 -$10,200 -$10,200 (2) After tax maintenance and insurance Cost -$1,500 -$1,500 -$1,500 -$1,500 -$1,500 -(3) CF=(1).+(2)+.(3) Total Cash Flow Terminal Payment ($5,000) -$11,700 -$11,700 -$8,790 -$16,700 SUM -$11,700 -$11,700 -$9,669 -$7,991 PV=CF/(1.1^N) Present Value of Cash Flow -$10,636 -$10,369 -$47,457 NET PRESENT VALUE(NPV) of COSTS OF LEASE $47,457 Net Advantage to Leasing (NAL)=43156-47457 -$4,301 PURCHASE OPTION IS RECOMMENDED NAL is negative Financial concepts needed: 1.Effects of taxation of interest, lease and other expenses 2. Depreciation and depreciation tax shield 3.Time Value of Money (Discounted cash flow) 4. After tax cost of debt 5. Reducing balance repayment of loan Font Algnnent Sугes Celns Ciipboard 9 INumper Editing fe -РMТ(н18, H17,-н16) H19 D K 14 15 INTEREST AND PRINCIPAL REPAYMENT ON AMOUNT BORROWED $60,000 16 Amount Borrowed = Pv Number of years of repayment 17 Nper 18 12% Rate Interest Rate $16,645 (Using PMT function of excelwith Rate=12% Annual repayment in five equal instalments 19 PMT 20 REPAYMENT SCHEDULE