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Question: As a financial analyst for Muffin Construction, you have been asked to recommend the method of financing the acquisition of new equipment needed by the firm. The equipment has a useful life of 8 years. If purchased, the equipment, will cost $700,000, will be appreciated under MACRS rule for 7-year class assets. If purchased, the needed funds can be borrowed at a 10% pre-tax annual rate. Muffin's weighted after-tax rate of capital is 12%. The actual salvage value at the end of 8 years is expected to be $50,000. Muffin's marginal ordinary tax rate is 40%. Annual, beginning-of-the-year lease payments would be $160,000. a. Compute the net advantage to leasing. b. Should Muffin lease or own the equipment?
Leasing:Leasing is a financial contract between two parties the lessee and the lessor. In this contract, the lessor allows another party to use some assets for a fixed period of time in exchange for a periodic fee.
Answer and Explanation:
Cost of owning | 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | | MACRS | | 14.29% | 24.49% | 17.49% | 12.49% | 8.93% | 8.92% | 8.93% | 4.46% | | Salvage value | | | | | | | | | 50,000 | | Book value | | | | | | | | | 0 | | Equipment cost | -700,000 | | | | | | | | | | Loan amount | 700,000 | | | | | | | | | | Interest expense | | -70,000 | -70,000 | -70,000 | -70,000 | -70,000 | -70,000 | -70,000 | -70,000 | | Tax saving on interest @ 40% | | 28,000 | 28,000 | 28,000 | 28,000 | 28,000 | 28,000 | 28,000 | 28,000 | | Principal payment | | | | | | | | | -700,000 | | Tax saving on depreciation | | 100,030 | 171,430 | 122,430 | 87,430 | 62,510 | 62,440 | 62,510 | 31,220 | | Salvage value after tax | | | | | | | | | 30,000 | | Net cash fllow | 0 | 58,030 | 129,430 | 80,430 | 45,430 | 20,510 | 20,440 | 20,510 | -680,780 | | PV of net cash flow @ 12% | -2,571.10 | | | | | | | | |
Cost of Leasing | 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | | Lease payment | -160,000 | -160,000 | -160,000 | -160,000 | -160,000 | -160,000 | -160,000 | -160,000 | | | Tax saving from lease | 64,000 | 64,000 | 64,000 | 64,000 | 64,000 | 64,000 | 64,000 | 64,000 | | | Net cash flow | -96,000 | -96,000 | -96,000 | -96,000 | -96,000 | -96,000 | -96,000 | -96,000 | 0 | | PV of net cash flow @ 12% | -534,120.63 | | | | | | | | |
NAL = PV of leasing - PV of owning NAL = -534,120.63 - (-2,571.10) NAL = -$531,549.53
Muffin should own the equipment.
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