Big Sky Mining Company must install $1.5 million of new machinery in its Nevada mine

1) Big Sky Mining Company must install $1.5 million of new machinery in its Nevada mine. It can obtain a bank loan for 100% of the purchase price, or it can lease the machinery. Assume that the following facts apply:

1. The machinery falls into the MACRS 3-year class.

2. Under either the lease or the purchase, Big Sky must pay for insurance, property taxes, and maintenance.

3. The firm's tax rate is 40%.

4. The loan would have an interest rate of 15%.

5. The lease terms call for $400,000 payments at the end of each of the next 4 years.

6. Big Sky Mining has no use for the machine beyond the expiration of the lease, and the machine has an estimated residual value of $250,000 at the end of the 4th year.

What is the NAL (Net Advantage of Leasing) of the lease?



You would have cash flows for owning and leasing in years 1-4. You should also have tax on residual value in year 4 in cost of owning.



NPV LEASE ANALYSIS



Year = 0 1 2 3 4

Cost of Owning

After-tax loan payments ($135,000)($135,000) ($135,000) ($1,635,000)

Maintenance Cost

Tax savings from main.

Tax savings from depr. $198,000 $270,000 $90,000 $42,000

Residual value $250,000

Tax on residual value

Net cash flow $0 $63,000 $135,000 ($45,000) ($1,443,000)

PV ownership cost @ 9% $ (885,580.87)

Cost of Leasing

Lease payment(AT) ($240,000) ($240,000) ($240,000) ($240,000)

Net cash flow $0 ($240,000) ($240,000) ($240,000) ($240,000)

PV of leasing @ 6.5% $ (777,532.77)



Cost Comparison

PV ownership cost @ 9% $ (885,580.87)

PV of leasing @9% $ (777,532.77)

Net Advantage to Leasing $ 108,048.10

2) Net advantage to leasing problem (NAL).

ABC Industries is negotiating a lease on a new piece of equipment which would cost $100,000 if purchased. The equipment falls into the MACRS 3-year class, and it would be used for three years and then sold, because ABC plans to move to a new facility at that time. It is estimated that the equipment could be sold for $30,000 after three years of use. A maintenance contract on the equipment would cost $3,000 per year, payable at the beginning of each of the three years of usage. Conversely, ABC could lease the equipment for three years for a lease payment of $29,000 per year, payable at the beginning of each year. The lease would also include maintenance. ABC is in the 20 percent tax bracket, and it could obtain a three-year simple interest loan to purchase the equipment at a before tax cost of 10 percent. Should ABC lease or buy?



NPV LEASE ANALYSIS



Year = 0 1 2 3

Cost of Owning

After-tax loan payments ($8,000) ($8,000) ($108,000)

Maintenance Cost (after tax) ($2,400) ($2,400) ($2,400) $0

Depreciation $33,000 $45,000 $15,000

Tax savings from depr. $6,600 $9,000 $3,000

Residual value $30,000

Tax on residual value ($4,600)

Net cash flow ($2,400) ($3,800) ($1,400) ($79,600)

PV ownership cost @ 8% $ (70,307.84)



Cost of Leasing

Lease payment $29,000 $29,000 $29,000 $0

Tax savings from leas($5,800) ($5,800) ($5,800) $0

Net cash flow $23,200 $23,200 $23,200 $0

PV of leasing @ 8% $ 64,571.74



Cost Comparison

PV ownership cost @ 8% $ (70,307.84)

PV of leasing @ 8% $ 64,571.74

Net Advantage to Leasing $ (5,736.10)
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