Question

Carmichael Cleaners needs a new steam finishing machine that costs $100,000. The company is evaluating whether it should lease or purchase the machine. The equipment falls into the MACRS 3-year class, and it would be used for 3 years and then sold, because the firm plans to move to a new facility at that time. The estimated value of the equipment after 3 years is $30,000. A maintenance contract on the equipment would cost $3,000 per year, payable at the beginning of each year. Alternatively, the firm could lease the equipment for 3 years for a lease payment of $29,000 per year, payable at the beginning of each year. The lease would include maintenance. The firm is in the 20% tax bracket, and it could obtain a 3-year simple interest loan, interest payable at the end of the year, to purchase the equipment at a before-tax cost of 10%. If there is a positive Net Advantage to Leasing the firm will lease the equipment. Otherwise, it will buy it. What is the NAL? (Note: Assume MACRS rates for Years 1 to 4 are 0.3333, 0.4445, 0.1481, and 0.0741.)

a. $5,734

b. $6,023

c. $6,640

d. $6,324

e. $6,972

Answer 1

We will have to calculate the present value of cash outflow under both the option that is buying machine or leasing the machine
Net Advantage to Leasing would occur when the present value cash outflow under leasing is lower than the present value of cash outflow from purchase of machine and is the difference between both the option
We would first calculate present value of cash outflow under leasing option
Discount rate to be use is after tax interest rate = 10%*(1-0.20)							8.00%
Lease payment is made at the beginning of the year
Year	Lease amount*(1-Tax Rate)	Discount Factor @ 8%		Present Value (Lease Amount*Discount Factor)
0	$23,200	1	1/(1.08^0)	$23,200.00
1	$23,200	0.92593	1/(1.08^1)	$21,481.48
2	$23,200	0.85734	1/(1.08^2)	$19,890.26
				$64,571.74
Present Value of cash outflow under leasing option is $ 80,714.68
Now we would calculate present value of cash flow under purchase option
Depreciation Calculation		0	1	2	3	Total
MACRS Factor			0.3333	0.4445	0.1481
Depreciation (Cost of Machine*MACRS rate)			33330	44450	14810	92590
Loan Repayment					-$100,000
Interest Expense	(10%*100000)		-$10,000	-$10,000	-$10,000
Tax Savings on Interest	(Interest Expense*Tax Rate)		$2,000	$2,000	$2,000
Maintenance Expense		-$3,000	-$3,000	-$3,000
Tax Savings on Maintenance Expense	(Maintenance Expense*Tax Rate)	$600	$600	$600
Tax Savings on Depreciation	(Depreciation Expense*Tax Rate)		6666	8890	2962
Net Cash outflow		-2400	-3734	-1510	-105038
Salvage Value before Taxes					$30,000
Book Value	Cost - Depreciation				$7,410
Taxable Salvage Value					$22,590
Tax on salvage value					-$4,518
Salvage value after taxes					$25,482
Total Net CF		-2400	-3734	-1510	-79556
Discount Factor		1.00000	0.92593	0.85734	0.79383
Present Value		-2400.00	-3457.41	-1294.58	-63154.12	-70306.11
Present Value of cash outflow	$70,306.11
Net Advantage of Leasing = $ 70306.11 - $ 64571.74		$5,734.37
		$5,734	rounded to the nearest whole number
Therefore correct answer is option (a) - $ 5734