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Lee Wah Press (LWP) is considering a leasing arrangement to finance some special printing machines that it needs for production during the next three years
Lee Wah Press (LWP) is considering a leasing arrangement to finance some special printing machines that it needs for production during the next three years.
A planned change in the company’s production technology will make the new machine obsolete after 3 years. LWP will depreciate the new machine on a straight-line basis towards zero salvage value. The firm can borrow the installed cost of $480,000, at 10% interest per annum, calculated on an annual reducing balance, to buy the new machine or make three equal beginning-of-year lease payments of $210,000 should it decide to take up lease financing.
Annual maintenance costs associated with ownership, payable at the end of year, are estimated at $25,000. Annual insurance premium associated with the purchase is estimated to be at $6,000, payment is on a cash-before-cover basis. Should LWP opt for lease financing, all other costs will be borne by the lessor. LWP tax rate is 40%.
What is the net advantage to leasing (NAL)? Which option should LWP select, lease financing or purchase outright via bank borrowing?
Required:
- The annual after-tax cash outflow of the lease option in Year 1, Year 2, and Year 3 is ?
- The present value of the after-tax cash outflows of the lease option is?
- The annual loan payment amount of the purchase option in Year 1, Year 2 and Year 3 is?
- The interest expense of the purchase option in Year 1 is?
- The interest expense of the purchase option in Year 2 is?
- The interest expense of the purchase option in Year 3 is?
- The annual maintenance cost associated with the purchase option in Year 1, Year 2, and Year 3 is ?
- The annual insurance premium associated with the purchase option in Year 1, Year 2, and Year 3 is?
- the annual depreciation amount associated with the purchase option in Year 1, Year 2 and Year 3 is?
- The total deduction amount for the purchase option eligible for tax shield in Year 0 is?
- The total deduction amount for the purchase option eligible for tax shield in Year 1 is?
- The total deduction amount for the purchase option eligible for tax shield in Year 2 is ?
- The total deduction amount for the purchase option eligible for tax shield in Year 3 is?
- The tax shield amount in Year 0 is?
- The tax shield amount in Year 1 is ?
- The tax shield amount in Year 2 is?
- The tax shield amount in Year 3 is?
- The after-tax cash outflow associated with the purchase option in Year 0 is?
- The after tax cash outflow associated with the purchase option in Year 1 is ?
- The after-tax cash outflow associated with the purchase option in Year 2 is?
- he after tax cash outflow associated with the purchase option in Year 3 is?
- The present value of the after-tax cash outflows of the purchase option is?
- The Net Advantage of Leasing (NAL) is?
- Should LWP lease or purchase the special printing machine?
Expert Solution
a). After-tax cost of debt = interest rate*(1-Tax rate) = 10%*(1-40%) = 6%
This will be used as the discount rate.
Annual lease payment = 210,000
Annual after-tax lease payment = 210,000*(1-40%) = 126,000
b). PV of lease option: PMT = 126,000; N = 3; rate = 6%; Type = 1 (since beginning of the year payments), solve for PV.
PV = 357,007.48
c). PV (loan amount) = 480,000; N (number of payments) = 3; rate = 10%, solve for PMT.
Annual loan payment = 193,015.11
Loan payment schedule:
d). Year 1 interest expense = 48,000
e). Year 2 interest expense = 33,498.49
f). Year 3 interest expense = 17,546.83
g). Annual maintenance cost = 25,000
h). Annual insurance premium = 6,000
i). Annual depreciation = price of machine/life = 480,000/3 = 160,000
j). Total deduction amount eligible for tax shield at T = 0 is 0.
k). Total deduction amount eligible for tax shield at T = 1 is depreciation + interest expense
= 160,000 + 48,000 = 208,000
l). Total deduction amount eligible for tax shield at T = 2 is depreciation + interest expense
= 160,000 + 33,498.49 = 193,498.49
m). Total deduction amount eligible for tax shield at T = 3 is depreciation + interest expense
= 160,000 + 17,546.83 = 177,546.83
n). Tax shield in Year 0 = 0
o). Tax shield in Year 1 = deductible amount*Tax rate = 208,000*40% = 83,200.00
p). Tax shield in Year 2 = 193,498.49*40% = 77,399.40
q). Tax shield in Year 3 = 177,546.83*40% = 71,018.73
r). After-tax cash flow for purchase option in Year 0 = 0
s). After-tax cash flow for purchase option in Year 1 = after-tax maintenance cost + after-tax annual premium + loan installment - tax shield
= 25,000*(1-40%) + 6,000*(1-40%) + 193,015.11 - 83,200 = 128,415.11
t). After-tax cash flow for purchase option in Year 2 = 25,000*(1-40%) + 6,000*(1-40%) + 193,015.11 - 77,399.40 = 134,215.71
u). After-tax cash flow for purchase option in Year 3 = 25,000*(1-40%) + 6,000*(1-40%) + 193,015.11 -
71,018.73 = 140,596.37
v). PV of after-tax cash outflows of purchase option = 128,415.11/(1+6%) + 134,215.71/(1+6%)^2 + 140,596.37/(1+6%)^3 = 358,645.26
w). Net advantage of leasing = PV of purchase option - PV of lease option
= 358,645.26 - 357,007.48 = 1,637.78
x). Since NAL is positive, the machine should be leased.
Note: Insurance premium payments are assumed to be made at the end of the year since the question does not mention the timing of payments. If the timing is changed, the calculations will change, as well.
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