Question

Dakota Trucking Company (DTC) is evaluating a potential lease for a truck with a 4-year life that costs $40,000 and falls into the MACRS 3-year class. If the firm borrows and buys the truck, the loan rate would be 10%. The truck will be used for 4 years, at the end of which time it will be sold at an estimated residual value of $10,000. If DTC buys the truck, it would purchase a maintenance contract that costs $1,000 per year, payable at the end of each year. The lease terms call for a $10,000 lease payment (4 payments total) at the beginning of each year. DTC's tax rate is 40%. Should the firm lease or buy? (Note: MACRS rates for Years 1 to 4 are 0.33, 0.45, 0.15, and 0.07.) Question 3) What is IPO underpricing?

Answer 1

a)		0	1	2	3	4
	LEASING:
	After tax lease rent [10000*(1-40%)	$         -6,000	$         -6,000	$        -6,000	$        -6,000
	After tax cash outflows	$         -6,000	$         -6,000	$        -6,000	$        -6,000
b)	BUYING:
	Loan installment = 40000*0.1*1.1^4/(1.1^4-1) =	$        12,619
	Loan amortization:
	Beginning balance of loan		$        40,000	$       31,381	$        21,900	$        11,471
	Interest at 10%		$           4,000	$          3,138	$          2,190	$          1,147
	Total		$        44,000	$       34,519	$        24,090	$        12,618
	Installment		$        12,619	$       12,619	$        12,619	$        12,618
	Ending balance of loan		$        31,381	$       21,900	$        11,471	$                   0
	Depreciation		$        13,200	$       18,000	$          6,000	$          2,800
	After cash flows of buying:
	Principal repayment		$         -8,619	$        -9,481	$      -10,429	$      -11,471
	After tax interest		$         -2,400	$        -1,883	$        -1,314	$            -688
	Tax shield on depreciation at 40%		$           5,280	$          7,200	$          2,400	$          1,120
	After tax residual value = 10000*(1-40%) =					$          6,000
	After tax maintenance cost (1000*60%)		$             -600	$            -600	$            -600	$            -600
	After tax cash outflows		$         -6,339	$        -4,764	$        -9,943	$         -5,639
c)	PVIF at 6% [PVIF = 1/1.06^n]	1	0.94340	0.89000	0.83962	0.79209
	PV of leasing	$         -6,000	$         -5,660	$        -5,340	$        -5,038
	Total PV	$      -22,038
	PV of buying		$         -5,980	$        -4,240	$        -8,348	$         -4,467
	Total PV	$      -23,035
d)	Leasing is preferred as the PV of cash outflows is lower.