The X Company is considering the acquisition of a new processor that has an estimated installed cost of $57,000. The processor has an expected life of 5 years and will be depreciated over a 5 year ACRS life to a zero salvage value. However, it is expected that the processor can be sold at that time for $6,000. If purchased, the entire $57,000 would be borrowed at an interest rate of 9%. A capital budgeting analysis results in a positive NPV for the project. An alternative to purchase is to lease the asset for an annual lease payment of $13,500. The lease includes maintenance services estimated to cost Company C $3,000 per year if they were not included in the lease payment. Company C's cost of capital is 11% and its marginal tax rate is 34%. Evaluate the purchase and lease options and make a recommendation of which is preferred
The X Company is considering the acquisition of a new processor that has an estimated installed cost of $57,000. The processor has an expected life of 5 years and will be
The question is based on the concept of decision on buy or lease a machine based on the comparison of net cost.
The given data in question as ,
Price of machine=$57,000
Salvage value after 5 year= $6,000
Depreciation = 5 years MACRS
Annual lease payment = $13,500
Tax rate = 34%
Cost of capital =11%
Cost of loan = 9%
Depreciation calculation:
| Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 |
| Depreciation Rate | 20% | 32% | 19.20% | 11.52% | 11.52% | 5.76% | |
| Depreciation value | $0 | $11,400 | $18,240 | $10,944 | $6,566 | $6,566 | $3,283 |
| Asset book value | $57,000 | $45,600 | $27,360 | $16,416 | $9,850 | $3,283 | $0 |
Salvage value of machine after tax after 5 years
Capitalized cost of buy option,
| Year | 0 | 1 | 2 | 3 | 4 | 5 |
| Cost | -$57,000 | |||||
| Tax shield on depreciation (depreciation *34%) | $3,876 | $6,202 | $3,721 | $2,233 | $2,233 | |
| After Tax salvage value | $5,076 | |||||
| Maintenance cost | -$3,000 | -$3,000 | -$3,000 | -$3,000 | -$3,000 | |
| Net Cash flow | -$57,000 | $876 | $3,202 | $721 | -$767 | $4,309 |
| PV of net cash flow @11% | -$57,000.00 | $789.19 | $2,598.49 | $527.16 | -$505.53 | $2,556.93 |
| Sum of PV net cash flow | -$51,033.76 |
Tax benefit of the interest payment on loan =$57,000∗9%∗34%=$1,744
PV of the interest tax shield on loan=$1,744∗PVIFA(11%,5 years) =$1,744∗3.69590=$6,446
Net present value of the cost to buy =-$51,034+$6,446=-$44,587.76 ------- (1)
Capitalized cost of lease option,
After-tax lease payment = -$13,500 ∗ (1−34%)= -$8,910
PV (due) of the lease payments
As cost in buying option (1) > cost option in lease (2), the lease option is recommended
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