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Example: Anderson equipment Company is considering a lease analysis on some assembly line equipment that it will procure in the coming year. The following data have been developed. Anderson plans to acquire automated assembly line equipment with a 10-year life and a cost of $10 million, delivered and installed. However, Anderson plans to use the equipment for only five years, for it will discontinue the product line at that time. Anderson can borrow the required $10 million at a beforetax cost of 10 percent. The equipments estimated scrap value is $50,000 after 10 years of use, but its salvage value after five years of use is $1 million.

Anderson can lease the equipment for five years at a rental charge of $2.75 million per year payable at the beginning of each year, but the lessor will own the equipment upon expiration of the lease. The lease contract stipulates that the lessor will maintain the equipment q p at no additional charge g to Anderson. However, , if Anderson borrows and buys, it will have to bear the cost of maintenance, which will be performed by the equipment manufacturer at a fixed contract rate of $500,000 per year payable at the beginning of each year. The maintenance cost to Anderson is tax deductible. The equipment falls under the MACRS 5-year class life. Andersons marginal tax rate is 40 percent and the lease qualifies for a guideline lease. Should Anderson lease or buy the assembly line equipment? Make your decision based on the NPV and IRR analyses.

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

A. Buy
Net purchase price Maintenance cost Maintenance tax savings Depreciation tax savings Salvage value Tax effect on sale Netcash flow: NCFBUY ($10,000,000) (500,000) 200,000 (500,000) 200,000 800,000 (500,000) 200,000 1,280,000 (500,000) 200,000 760,000 (500,000) 200,000 480,000

($10,300,000) ($2,750,000) $1,100,000 ($1,650,000) $8,650,000 10%(1-0.4) $103,389 5.52%

500,000 ($2,750,000) 1,100,000 ($1,650,000) ($2,150,000) 6% Positive < kDAT

980,000 ($2,750,000) 1,100,000 ($1,650,000) ($2,630,000) Accept lease Accept lease

460,000 ($2,750,000) 1,100,000 ($1,650,000) ($2,110,000)

180,000 ($2,750,000) 1,100,000 ($1,650,000) ($1,830,000)

480,000 1,000,000 (200,000) 1,280,000

B. Lease
Lease payments Payment tax savings Net cash flow:NCFLEASE C. /\ NCF=NCFLEASE-NCFBUY After-tax cost of debt NPV =NAL IRR

($1,280,000)

Footnotes to Calculations: Maintenance tax savings = Maintenance cost X Tax rate Depreciation tax savings = Cost of equipment X MACRS rate X Tax rate Tax effect on sale = (Yr.5 Salvage value Yr. Book value) X Tax rate Payment tax savings = Annual lease payment X tax rate

PV of cost with Bying Year CFt Dis.Factor 0 ($10,300,000) 1.0000 1 500,000 0.9434 2 980,000 0.8900 3 460,000 0.8396 4 180,000 0.7921 5 1,280,000 0.7473 PVBUY PV of cost with Leasing Year CFt Dis.Factor 0 ($1,650,000) 1.0000 1 (1,650,000) 0.9434 2 (1,650,000) 0.8900 3 (1,650,000) 0.8396 4 (1,650,000) 0.7921 5 0 0.7473 PVBUY NAL ($7367424) - ($7470813)

PVCFt ($10,300,000) $471,698 $872,197 $386,225 $142,577 $956,490 ($7,470,813) PVCFt ($1,650,000) ($1,556,604) ($1,468,494) ($1,385,372) ($1,306,955) $0 ($7,367,424) $103,389

EVALUATION BY LESSOR As with the lessee, the lessor also needs to find out if the lease is a good investment for the party who must put up the money. Any potential lessor has to know the rate of return p on the capital invested in the lease. The lessors analysis involves
(1)developing the cash flows from the lease (2)calculating the NPV at the lessors opportunity cost of capital and (3) finding out the IRR of those cash flows. The lease will be acceptable if the NPV is positive and the IRR is higher than the opportunity cost of capital.

Example: Refer to the Anderson problem. Suppose that the investor can buy 5-year bonds that have a 9 percent yield to maturity providing an after f tax yield of 9%(1-0.4) = 5.4%. This is the after-tax return that the investor can obtain on alternative investment of similar risk, i.e. the opportunity cost of capital.

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Thank You
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Lease investment
Net purchase price Maintenance cost Maintenance tax savings Depreciation tax savings Salvage value Tax effect on sale Lease payments Payment tax Net cash flow:NCF Opportunity cost of capital NPV IRR ($10,000,000) (500,000) 200,000 (500,000) 200,000 800,000 (500,000) 200,000 1,280,000 (500,000) 200,000 760,000 (500,000) 200,000 480,000

480,000 1,000,000 (200,000)

$2,750,000 (1,100,000) ($8,650,000) 9%(1-0.4) $24,797 5.52%

$2,750,000 (1,100,000) $2,150,000 5.40% Positive >kDAT

$2,750,000 (1,100,000) $2,630,000

$2,750,000 (1,100,000) $2,110,000

$2,750,000 (1,100,000) $1,830,000

$1,280,000

Intermediate Financial Management, 5th ed. Eugene F. Brigham & Louis C. Gapinsky The Dryden Press, Hartcourt Brace College Publishers 1996

Accept lease investment Accept lease investment

The analyses of the Anderson lease from both the lessee and the lessors perspective reveals that the lease will be advantageous to the lessor and the lessee. Therefore, the lease agreement should be signed.