QUESTION NO 01 :
Carter Company wishes to expand its productive capacity. In order to do so it must
acquire a Tractor costing $400,[Link] machine can be purchased or leased. The firm
is in the 40 percent tax bracket and its after-tax cost of debt is currently 6 percent If the
firm purchased the machine, the purchase would be totally financed with 10 percent
loan requiring equal annual end-of-year payments over 5 years. The machine would be
depreciated straight-line over its 5-year life. A salvage value of zero is anticipated. The
life of a lease would be 5 years. The lessor intends to charge equal annual lease
payments that will enable it to earn 15 percent on its investment. In doing the following
calculations, round your answers to the nearest dollar.
(a) Calculate the annual loan payment paying 10 percent interest.
(b) Calculate the annual lease payment required in order to give the lessor its desired
return.
(c) Determine the after-tax cash outflows associated with each alternative.
(d) Find the present value of the after-tax cash outflows using the after-tax cost of debt.
(e) Which alternative (i.e., lease or purchase) would you recommend? Why?
DATA:
COST OF MACHINE = 400,000
TAX RATE = 40%
AFTER TAX RATE = 6%
NO OF YEARS = 5
SALVAGE VALUE = 0
DEPRICIATION = 80,000
SOLUTION:
A ANNUAL LOAN PAYMENT
Annual loan payment = Cost of Machine
[1-(1+r)]^-n
r
Annual loan payment = 400,000
[1-(1+10%]^-5
10%
Annual loan payment = 400,000
3.7908
Annual loan payment = 105519
B ANNUAL LEASE PAYMENT
AT 15 %
Annual lease payment = Cost of Machine
[1-(1+r)]^-n
r
Annual lease payment = 400,000
[1-(1+15%]^-5
15%
Annual lease payment = 400,000
3.3521
Annual lease payment = 119328
C AFTER TAX CASH OUT FLOW
FIRST WE NEED TO MAKE AN AMORTIZATION TABLE
FOR PV CASH FLOW
AT 10 %
AMORTIZATION TABLE
PRINCIPLE
YEAR PRINCIPLE INSTALLMENT = PRINCIPLE + INTEREST CLOSING
1 400,000 105519 65519 40000 334,481
2 334,481 105519 72071 33448 262,410
3 262,410 105519 79278 26241 183,132
4 183,132 105519 87206 18313 95,926
5 95,926 105519 95926 9593 0
AT 15 %
PRINCIPLE
YEAR PRINCIPLE INSTALLMENT = PRINCIPLE + INTEREST CLOSING
1 400,000 119328 59328 60000 340,672
2 340,672 119328 68227 51101 272,445
3 272,445 119328 78461 40867 193,984
4 193,984 119328 90230 29098 103,754
5 103,754 119328 103,754 15574 0
NOW,
AT 10 %
PRESENT VALUE OF CASH FLOW BORROWING
TAX SAVING
CASH PVIF
TERMS DEPRECIAT x (TAX CFAT PV
FLOW 6%
INTEREST + ION RATE)
1 105519 40000 80,000 40% 57519 0.9434 54263
2 105519 33448 80,000 40% 60140 0.8900 53524
3 105519 26241 80,000 40% 63023 0.8396 52915
4 105519 18313 80,000 40% 66194 0.7921 52432
5 105519 9593 80,000 40% 69682 0.7473 52070
265,204
AT 15 %
TAX SAVING
TERM CASH PVIF
DEPRECIAT x (TAX CFAT PV
S FLOW 9%
INTEREST + ION RATE)
1 119328 60000 80,000 40% 63328 0.9174 58099
2 119328 51101 80,000 40% 66888 0.8417 56298
3 119328 40867 80,000 40% 70981 0.7722 54811
4 119328 29098 80,000 40% 75689 0.7084 53620
5 119328 15574 80,000 40% 81098 0.6499 52706
275534
D AFTER TAX CASH OUT FLOW USING AFTER TAX COST DEBT
PRESENT VALUE OF CASH FLOW AFTER TAX COST DEBT (Leasing)
TERM LEASE/ TAX SAVING PVIF
CFAT PV
S RENTAL 6%
47731
1 to 5 119328 71597 4.2124 301592
E RECOMMENDATION
Leasing results in Higher after-tax cash outflows and lower present value of total costs
compared to borrowing. Therefore, borrowing is the better financial decision for Carter
Company.
QUESTION NO 02 :
Roger Limited is interested in acquiring the use of an asset costing Rs. 500,000/-
It has two options:
1. to borrow the amount at18% per annum repayment in 5 equal annual installments at
the start of each year or
2. to take on lease the asset for a period of 5 years at the start of each year of
Rs. 120,000/-
The corporation tax rate is 35% and the depreciation is allowed on straight line
method. The asset will have a salvage value of Rs. 180,000 at the end of the 5th year.
Required:
You are required to advice the company about lease or buy decision.
DATA:
COST OF MACHINE = 500,000
INTEREST RATE = 18%
TAX RATE = 35%
NO OF YEARS = 5
SALVAGE VALUE = 180,000
DEPRICIATION = 64000
Annunity Due Because Start of the year
SOLUTION:
Step 01
Installment Amount = Cost of Machine
[1-(1+r)]^-n X (1+r)
r
Installment Amount = 500,000
[1-(1+18%]^-5 X (1+18%)
18%
Installment Amount = 500,000
3.6901
Installment Amount = 135498
Step 02
AMORTIZATION TABLE
INSTALLMENT PRINCIPLE
YEAR PRINCIPLE = PRINCIPLE + INTEREST CLOSING
0 500,000 135498 135498 0 364,502
1 364,502 135498 69888 65610 294,614
2 294,614 135498 82467 53031 212,147
3 212,147 135498 97312 38186 114,835
4 114,835 135498 114,835 20663 0
PRESENT VALUE OF CASH FLOW BORROWING
Step 03
TAX SAVING
TERM CASH PVIF
INTEREST DEPRECIATI x (TAX CFAT PV
S FLOW 11.7%
+ ON RATE)
0 135498 0 0 0% 135498 1.0000 135498
1 135498 65610 64,000 35% 90134 0.8953 80693
2 135498 53031 64,000 35% 94537 0.8015 75770
3 135498 38186 64,000 35% 99733 0.7175 71561
4 135498 20663 64,000 35% 105866 0.6424 68005
for
depreciati
on 5 0 -64000 35% -22400 0.5751 -12882
For
salvage 5 -180,000 -180,000 0.5751 -103518
Step 04
PRESENT VALUE OF CASH FLOW AT LEASING
LEASE/ TAX SAVING PVIF
TERMS CFAT PV
RENTAL 11.7%
0- 120,000 0 120000 1.0000 120000
1 to 4 120000 42000 78000 3.0566 238418
5- 0 -42000 -42000 0.5751 -24154
334,264
E RECOMMENDATION
We recommend that Roger Limited should borrowing the asset instead of leasing it. Borrowing is
the more cost-effective option based on the comparative analysis of after-tax cash flows.
