Question

A construction company is considering whether to lease or buy equipment for its new 4-year project. If they buy the equipment, it will have an initial investment cost of $630,000 with annual costs of $42.000. At the end of the 4 years the equipment can be sold for an estimated $378,000. For tax purposes, the company will use MACRS-ADS depreciation on the equipment. If they decide to lease, it will cost them $210,000 per year all inclusive. However, they will also be required to make a $125,000 initial deposit that ill be refunded in full at the end of the 4-year lease. The refund is not taxable. The company's marginal effective tax rate is 28% and the capital gain tax rate is 15%. The after-tax MARR is 17% per year. Based on the after-tax cash flows, what would you recommend, leasing or purchase? Click the icon to view the partial listing of depreciable assets used in business Click the icon to view the interest and annuity table for discrete compounding when the MARR is 17% per year. Use the table to determine the ADS recovery period for construction equipment, and hence the depreciations, taxes and after-tax cash flows for each of the four years for the lease and purchase options. (Costs should be negative cash flows and revenues positive. Round to the nearest dollar.) Year ATCF (Lease) ATCF(Purchase) Calculate the PW values for the two options. PWLease)(17%)n$ (Round to the nearest dollar.) PW(Purchase)(17%)-$□ (Round to the nearest dollar.) Based on the PW values, which option is more economical? OA. Leasing O B. Purchase
please answer them all and mark the answers . thanks

Answer 1

Part1

Present worth (PW) of lease :

Cash flows are

Time cashflows

0 -125000

1 to 4 -210000 p.a. ( lease rental)

-210000× (1-.28)= $ -151200 p.a. after tax

4 125000

PW = -125000-151200×AF(17%,4) +125000× PVF(17%,4)

AF(17%,4) = annuity factor = (1-1.17^-4)/.17 = 2.74

PVF(17%,4)= present value factor= 1/1.17^4 = .5337

PW = -125000 - 151200× 2.74 +125000×.5337 = -$ 472576

PW of purchase

Cash flows

At time 0  

Initial investment = $630000

From time 1 to 4

After tax annual cost = 42000×(1-.28)= $30240

PV of this = 30240×AF(17%,4)= 30240×2.74= $82858

Depreciation as per MACRS Ads, Since question doesn't provide details which method to use we assume that SLM os being used as per this method annual Depreciation = 630000/4= $157500

Annual depreciation tax shield(DTS) = tax rate× 157500= .28×157500= $44100

PV of this Tax shield = 44100×2.74= $120834

At time 4

Sale of equipment = $378000

Capital gain= 378000 because ads SLM depreciate the value toll 0

Capital gains tax= 378000×15%= $56700

After tax sale= 378000- 56700= $321300

PV of this = 321300×PVF(17%,4)= 321300×.5337= 171478

Now the PW for purchase is given by

PW= PV of DTS+ PV of after tax sale - PV of after tax cost - intial cost

= 120834 +171478-82858-630000= - $420546

Since PW of total cost in less in option 2, we should go with this i.e. we should buy the equipment rather taking it on lease.