Question

In order to buy an automated packing machine for your factory, the cost would be $150,000. You have inquired at the bank about borrowing that amount and the bank would charge you a rate of 9.5% on the loan. The packing machine would be used for 10 years, at the end of which it would have no salvage value. It falls in an asset class with an allowable CCA rate of 10% per year. Use of the machine would reduce before-tax costs by $30,000 per year. Use of the machine would reduce packing machine from the manufacturer for lease payments of $25,000 per year (due at the beginning of each year). your firm's tax rate is 35%. Assuming that you will obtrain the new packing machine in some way, should you lease or buy it?

Answer 1

Buying option:

The loan amount is repayable together with interest of 9.5% on loan amount and is repayable over a period of 10 years assuming at the end of each year.

PVAF at the rate of 9.5% for 10 years is 6.2788

Annual payment= Cost if the machine ÷ PVAF = 150000÷6.2788= $23890 (rounded off)

Debt repayment schedule

End of Year	Total payment $	Interest $	Principal $	Principal amount Outstanding $
1	23890	14250 (150000*9.5%)	9640 (23890-14250)	140360 (150000-9640)
2	23890	13334 (140360*9.5%)	10556 (23890-10556)	129804 (140360-10556)
3	23890	12331	11559	118245
4	23890	11233	12657	105588
5	23890	10031	13859	91729
6	23890	8714	15176	76553
7	23890	7273	16617	59936
8	23890	5694	18196	41740
9	23890	3965	19925	21815
10	23890	2075 (Rounded off)	21815	------

Schedule of Cash Outflows ($)

1	2	3	4	3+4	5	6	7	6*7
Year	Debt payment	Interest	Dep		Tax shield (3+4)*0.35	Cash outflows 2-5	PV [email protected]%	PV
1	23890	14250	15000	29250	10238	13652	0.9418	12857
2	23890	13334	15000	28334	9917	13973	0.8871	12395
3	23890	12331	15000	27331	9566	14324	0.8355	11968
4	23890	11233	15000	26233	9182	14708	0.7869	11574
5	23890	10031	15000	25031	8761	15129	0.7411	11212
6	23890	8714	15000	23714	8300	15590	0.6980	10882
7	23890	7273	15000	22273	7796	16094	0.6574	10580
8	23890	5694	15000	20694	7243	16647	0.6192	10308
9	23890	3965	15000	18965	6638	17252	0.5832	10061
10	23890	2075	15000	17075	5976	17914	0.5493	9840
								111677

There is also saving of $30000 per year before tax

Saving after tax=30000*(1-0.35)=$19500

PV of saving = 19500*[email protected]%. for 10 years

PV of saving= 19500*7.2994= $142338

Net Saving for buying option = 142338-111677= $30661

Lease option:

Lease rent for years =$25000

Lease rental for Y1 beginning to Y10 beginning = 25000-tax saving

=25000*(1-0.35)= $16250

PV of outflows =25000+16250*[email protected]% for 9years

=25000+16250*6.750= $134688

Since the PV of outflows is lower in the buying option it is preferable to avail of the loan and purchase the machine.

Answer 2

To determine whether you should lease or buy the packing machine, we need to compare the after-tax costs of each option over the 10-year period. Let's calculate the after-tax costs for both scenarios:

Leasing: Lease payments per year: $25,000 Tax rate: 35%

After-tax cost of leasing per year = Lease payments - Tax savings on lease payments = $25,000 - ($25,000 * 35%) = $25,000 - $8,750 = $16,250

Total after-tax cost of leasing over 10 years = After-tax cost of leasing per year * Number of years = $16,250 * 10 = $162,500

Buying: Cost of the packing machine: $150,000 CCA rate: 10% Tax rate: 35% Annual tax savings due to CCA = Cost of the packing machine * CCA rate * Tax rate = $150,000 * 10% * 35% = $5,250

Net after-tax cost of buying per year = Before-tax cost savings - Annual tax savings due to CCA = $30,000 - $5,250 = $24,750

Total after-tax cost of buying over 10 years = Net after-tax cost of buying per year * Number of years = $24,750 * 10 = $247,500

Comparing the total after-tax costs: Leasing: $162,500 Buying: $247,500

Based on the comparison, leasing the packing machine would result in a lower after-tax cost over the 10-year period. Therefore, it would be more cost-effective to lease the machine rather than buying it.