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Ambassatours needs to add three double-decker buses to its tour vehicles fleet
Ambassatours needs to add three double-decker buses to its tour vehicles fleet. The cost of the buses will be $1,150,000 in total. British Leasing has offered to lease the buses to Ambassatours for a total of $230,000 per year for each of five years, with the lease payments payable in advance. The buses are estimated to be worth a total of $100,000 in 5 years. The buses are class 10.1 assets (CCA rate, 30%) with a useful life of five years, the firm's tax rate is 30% and Ambassatours' after- tax cost of debt is 8%. The present value of the CCA tax savings = $235,290. Under the terms of the lease, British Leasing has agreed to pay the $22,000 annual maintenance costs (before tax, end of year payment). Should Ambassatours lease or purchase the buses?
Expert Solution
Given Information
Purchase cost of buses = $1,150,000
Lease payment (payable in advance) per year = $230,000 per year (inclusive of $22,000 annual maintenance)
Period = 5 years
Depreciation Class = 10.1 (CCA rate, 30%)
Ambassador’s after tax cost of debt = 8%
Present value of CCA tax savings = $235,290
Annual maintenance costs (before tax, end of year payment) = $22,000
Present Value calculation of lease payments is as follows –
|
Lease |
0 |
1 |
2 |
3 |
4 |
5 |
|
Lease payment (payable in advance) |
(230,000) |
(230,000) |
(230,000) |
(230,000) |
(230,000) |
|
|
tax saving on lease payment |
69,000 |
69,000 |
69,000 |
69,000 |
69,000 |
|
|
Net cost |
(161,000) |
(161,000) |
(161,000) |
(161,000) |
(161,000) |
|
|
Discount Factor (1/(1+0.08)^Year) |
1.0000 |
0.9259 |
0.8573 |
0.7938 |
0.7350 |
|
|
Discounted Value |
(161,000) |
(149,074) |
(138,032) |
(127,807) |
(118,340) |
|
|
PV |
(694,252) |
In case of purchase, Present Value of maintenance costs after tax is calculated as follows-
|
Purchase |
0 |
1 |
2 |
3 |
4 |
5 |
|
Maintenance Cost (year end) |
(22,000) |
(22,000) |
(22,000) |
(22,000) |
(22,000) |
|
|
tax saving on maintenance cost |
6,600 |
6,600 |
6,600 |
6,600 |
6,600 |
|
|
Net cost |
(15,400) |
(15,400) |
(15,400) |
(15,400) |
(15,400) |
|
|
Discount Factor (1/(1+0.08)^Year) |
1.0000 |
0.9259 |
0.8573 |
0.7938 |
0.7350 |
0.6806 |
|
Discounted Value |
- |
(14,259) |
(13,203) |
(12,225) |
(11,319) |
(10,481) |
|
PV |
(61,488) |
Present Value of initial cost = - 1,150,000
Present Value of CCA tax savings = 235,290
|
Depreciation |
0 |
1 |
2 |
3 |
4 |
5 |
|
Opening Balance |
1,150,000 |
977,500 |
684,250 |
478,975 |
335,283 |
|
|
Depreciation Rate |
15% |
30% |
30% |
30% |
30% |
|
|
Depreciation Amount |
172,500 |
293,250 |
205,275 |
143,693 |
100,585 |
|
|
Closing Balance |
977,500 |
684,250 |
478,975 |
335,283 |
234,698 |
After 5 years, worth of buses = $100,000
Depreciated value of buses = 234,698
Tax on sale of buses = 30%* (100000-234698) = -40409 (negative tax implies tax credit i.e. deduction from business income)
So Net Terminal Cash Flow from selling buses at end of 5 years
=100000 – (-40409) = 140,409
So, Net Present Value of purchase = PV (initial investment) + PV(maintenance cost) + PV(CCA tax saving) + PV (Terminal Cash Flow)
=> Net Present Value = -1150000 -61488+235290+140409 = $ (835,788)
Ambassador should lease because the present value of leasing is less negative than present value of purchasing i.e. it is cheaper to lease than to purchase in present value terms
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