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Suppose Procter and Gamble? (P&G) is considering purchasing 18 million in new manufacturing equipment
Suppose Procter and Gamble? (P&G) is considering purchasing 18 million in new manufacturing equipment. If it purchases the?equipment, it will depreciate it on a? straight-line basis over the five? years, after which the equipment will be worthless. It will also be responsible for maintenance expenses of 1.00 million per year.? Alternatively, it can lease the equipment for 4.0 million per year for the five? years, in which case the lessor will provide necessary maintenance. Assume? P&G?s tax rate is 40% and its borrowing cost is 6.5% .
a. What is the NPV associated with leasing the equipment versus financing it with the lease equivalent? loan?
b. What is the? break-even lease ratethat ?is, what lease amount could? P&G pay each year and be indifferent between leasing and financing a? purchase?
1a The NPV is million
Expert Solution
Net advantage of leasing is the NPV of the lease relative to the purchase.
This is calculated by calculating the present value of the advantage each year.
Advantage each year = Cash flow with leasing - cash flow with buying.
Buying :
Cash outflow in year 0 = cost of equipment.
Cash inflow in each year = (annual depreciation * tax rate) - (annual maintenance cost * (1 - tax rate) (The depreciation is a tax-deductible expense, and hence provides a depreciation tax shield. This is treated as a cash inflow. The maintenance cost is also adjusted for tax.)
Annual depreciation tax shield = (cost of equipment / depreciable life) * tax rate = ($18,000,000 / 5) * 40%
Leasing :
Net cash outflow with leasing = lease payment * (1 - tax rate) = $4,000,000 * (1 - 40%) = $2,400,000.
NPV of leasing vs buying
Advantage each year = Cash flow with leasing - cash flow with buying.
Present value factor (discount factor) each year = 1 / (1 + discount rate)year.
Discount rate = after-tax cost of borrowing = interest rate on borrowing * (1 - tax rate) = 6.5% * (1 - 40%) = 3.9%.
Net Advantage of leasing each year = advantage amount * discount factor.
NPV of the lease relative to the purchase = $3,535,485.54
b]
break-even lease payment is the annual lease payment at which NAL is zero
break-even lease payment is calculated using GoalSeek in Excel
please see the attached file.
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