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LeasingACC1
Addendum Corp FINC 5880ANSWERS CLASS ASSIGNMENTSShanghai – 2015
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Class assignment Leasing:Assume the following case;
A company considers and investment of $100; the asset is depreciated over 2 years straight line; no residual value and tax rate 40%; if the company borrow the money the interest is 10% per year
A guideline lease requires a yearly lease fee of $55 Estimate the cash flows under the 2 scenarios; which
has the lower present value? (assume dcf=6% this is the after tax cost of debt: 10%*(1-40%))
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Answer: Buy and borrow…cash flows
Cash flows Year 0 Year 1 Year 2Cost -$100Loan +$100Interest -$10 -$10Tax saving +$4 +$4Repay loan -$100Tax saving depreciation
+$20 +$20
Total $0 +$14 -$86
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Answer: Lease cash flows
Cash flow Year 0 Year 1 Year 2
Lease payment
-$55 -$55
Tax saving lease payment
$22 $22
Total $0 -$33 -$33
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So calculate the PV (at 6%)
Buy/Borrow PV(6%): $ 63.33 Lease PV(6%): $60.50
The PV of the cost of Financing is lower under leasing…so…LEASE!
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Class Assignment: Leasing Consider a $10 M investment (10 year life) to be discontinued after 5 year
Borrow at 10% interest per year (before tax) if you Buy the Equipment
After 5 years residual value $2 M
A 5 year lease would trigger annual lease payments of $ 2,6M starting immediately in t=0
Under the lease the lessor maintains the equipment
If the company buy/borrow this equipment the maintenance cost will need to be paid additionally at $0.5M per year at the beginning of each year starting immediately (t=0)
Tax rate of the Lessee is 35%
Modified Accelerated Cost Recovery System (MACRS) depreciation: over the 5 years is resp. 20%, 32%, 19%, 12% and 11%
Compare the PV of the cost of owning (buy/borrow) with the PV of the cost of leasing….which one is lower?
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Answer: cash flows (in $ 1000) if you Borrow and Buy…
MUSD Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5After tax loan payments -650 -650 -650 -650 -10,650Maintenance costs -500 -500 -500 -500 -500Maintenance Tax savings 175 175 175 175 175DepreciationTax savings 700 1,120 665 420 385Residual Value 2,000Tax on residual value
-490
Total Cash Flow -325 -275 145 -310 -555 -8,755
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Answer: Leasing
MUSD Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
Lease payment -2,600 -2,600 -2,600 -2,600 -2,600
Payment Tax savings 910 910 910 910 910
Net Cash Flow -1,690 -1,690 -1,690 -1,690 -1,690
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Comparing…
In 1,000 USD Borrow & Buy Leasing
Present Value at 6.5% (10% after tax 35%)
- 7,534 - 7,480
So: leasing is beneficial
Disadvantage Advantage (54)
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Class assignment: From the Lessor’s point of view
Assuming: Lessor’s tax rate is 40% Lessor’s alternative investment is a 5 year bond with an after tax yield of
9%(1-40%)=5.4% Asset will be depreciated to book value of $600,000 after 5 years and the
before tax residual value is $ 2M This implies that Lessor can expect to receive $2M –
40%*$1.4M=$1,440,000 after the lease expires selling the asset directly…
Develop the cash flows and determine the IRR% of this investment Is 5.4%>,< or= IRR%? So what would the lessor invest his money in in
the Lease or the Bonds…?
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Answer: Lessor’s cash flow (IRR%=5.8% > 5.4% on the Bond….)
Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
purchase price asset
-10,000
Maintenance from t=0
-500 -500 -500 -500 -500
Maintenance tax savings 40%
200 200 200 200 200
Depreciation tax savings
800 1280 760 480 440
Lease payment
2,600 2,600 2,600 2,600 2,600
Tax on lease payment 40%
-1,040 -1,040 -1,040 -1,040 -1,040
Residual value 2,000
Tax on residual value(2000-600)*40%
-560
Cash flow -8740 2,060 2,540 2,020 1,740 1,880
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IRR% calculation in Excel
0 1 2 3 4 5 YEAR-8740 2,060 2,540 2,020 1,740 1,880 CASH FLOW 5.75% IRR%