FIN2101 BUSINESS FINANCE II MOdULE 8- ANALYSIS OF LEASES QUESTION 1 Source:Peirson, Bird,Brown and Howard 1995, Business Finance, 6 edn, McGraw-Hill, Sydney, pp 631-2 Ibus Ltd is considering the installation of a new computer. Because of uncertainty as to its future computing requirements and the prospect of advancements in computing technology, it is evaluating the acquisition of the computer by either purchasing it, or leasing it under a contract that includes a cancellation option. Informat ion relevant to the company's evaluation is as follows Purchase: The purchase price of the computer is $300 000 and it can be depreciated at a rate of 15% of the purchase price per annum, straightline. Ibus Ltd plans to operate the computer for a maximum of 5 years. The computer's disposal value at the end of 5 years is estimated to be $50000 Lease: The annual lease payments would be $90 000, payable at the beginning of each year The lease can be cancelled by Ibus ltd at any time without incurring any penalty payment The company income tax rate is 30% and the company pays tax in the same year. The required rate of return on the investment is 20% per annum and the after-tax cost of an equivalent loan is 10% per annum Should Ibus ltd purchase or lease the computer? QUESTION 2 BMC Plastics Ltd has decided to acquire a new pressing machine and is trying to decide between the leasing and buying alternatives. The machine can be purchased from the manufacturer for a delivered price of $85 000. The machine will be depreciated over a 10 year period to a zero salvage value although the firm estimates that it could be sold for a minimum of $5 000 at the end of the 10 years. Alternatively, the manufacturer has offered a financial lease at $11 000 per year for the 10 years, with all operating, maintenance and insurance expenses to be borne by the lessee. Lease payments are to be made in advance The firms risk-adjusted discount rate is 15% per annum, its before-tax interest rate on long- term debt is 11.43%, all depreciation is straightline, and the tax rate is 30%. All tax effects would be realised in the same year Which financing alternative would you recommend? (Round all discount rates to the nearest whole percentage, ie 54.12=54%0, 54.86=55%)
September 2003 FIN2101 BUSINESS FINANCE II MODULE 8 - ANALYSIS OF LEASES QUESTION 1 Source: Peirson, Bird, Brown and Howard 1995, Business Finance, 6th edn, McGraw-Hill, Sydney, pp. 631-2. Ibus Ltd is considering the installation of a new computer. Because of uncertainty as to its future computing requirements and the prospect of advancements in computing technology, it is evaluating the acquisition of the computer by either purchasing it, or leasing it under a contract that includes a cancellation option. Information relevant to the company’s evaluation is as follows: Purchase: The purchase price of the computer is $300 000 and it can be depreciated at a rate of 15% of the purchase price per annum, straightline. Ibus Ltd plans to operate the computer for a maximum of 5 years. The computer’s disposal value at the end of 5 years is estimated to be $50 000. Lease: The annual lease payments would be $90 000, payable at the beginning of each year. The lease can be cancelled by Ibus Ltd at any time without incurring any penalty payment. The company income tax rate is 30% and the company pays tax in the same year. The required rate of return on the investment is 20% per annum and the after-tax cost of an equivalent loan is 10% per annum. Should Ibus Ltd purchase or lease the computer? QUESTION 2 BMC Plastics Ltd has decided to acquire a new pressing machine and is trying to decide between the leasing and buying alternatives. The machine can be purchased from the manufacturer for a delivered price of $85 000. The machine will be depreciated over a 10 year period to a zero salvage value although the firm estimates that it could be sold for a minimum of $5 000 at the end of the 10 years. Alternatively, the manufacturer has offered a financial lease at $11 000 per year for the 10 years, with all operating, maintenance and insurance expenses to be borne by the lessee. Lease payments are to be made in advance. The firm's risk-adjusted discount rate is 15% per annum, its before-tax interest rate on longterm debt is 11.43%, all depreciation is straightline, and the tax rate is 30%. All tax effects would be realised in the same year. Which financing alternative would you recommend? (Round all discount rates to the nearest whole percentage, ie 54.12 = 54%, 54.86 = 55%)
QUESTION 3 Amalgamated Pulp Limited has decided to acquire a $300 000 pulp quality control device which has a useful life of 7 years, after which no salvage value is expected. Depreciation is allowable for tax purposes at the rate of 20% of the original price The company is trying to determine whether it is better to purchase the device or to lease it The interest rate at which the company could raise a medium-term loan is 10% per annum before tax. The company tax rate is 30%. If the asset is leased, a rental of $51 000 will be payable yearly in ad vance for 7 years. Assume that tax is in the same year Should the company purchase or lease the device? (Round all discount rates to the nearest whole percentage QUESTION 4 A firm can either lease or purchase a $50 000 asset. The firm depreciates assets via straightline, and the asset under consideration has a five-year normal recovery period. The firm's tax rate is 30% and its before-tax cost of borrowing is 10%. If leased the five annual lease pay ments are payable in advance. At what lease payment(rounded to the nearest dollar) is the firm indifferent between leasing and purchasing the asset? Assume tax is in the same year QUESTION 5 Alpine limited owns the build ing and land that comprises its head office. The build ing has a remaining life of 20 years, is being depreciated by the straightline method, and has a book value of $1. 1 million. The land has a book value of $500 000. At the end of the 20 years, it is expected that the building will be demolished at a cost of $100 000 and the vacant land sold for S1 million The Lease-All Company Limited has offered to pay Allpine Ltd $1.6 million for the land and building, and grant it a 20-year lease at $200 000 per year, payable yearly in advanc Allpine would pay for maintenance, insurance and municipal rates. It would have no right or interest in the property at the expiration of the lease The taxation laws do not allow depreciation of the build ing to be claimed as a deduction, but lease payments would be deductible for Alpine Ltd. The company tax rate is expected to remain at 30% over the next 20 years and Alpine expects to earn a profit in each of those years. Its after-tax opportunity cost of funds is 8% per annum Assuming tax is payable in the same year and there is no tax on the salvage value in Year 20 should Alpine enter into the sale-and-lease back agreement with the Lease- All Company Ltd?
September 2003 QUESTION 3 Amalgamated Pulp Limited has decided to acquire a $300 000 pulp quality control device which has a useful life of 7 years, after which no salvage value is expected. Depreciation is allowable for tax purposes at the rate of 20% of the original price. The company is trying to determine whether it is better to purchase the device or to lease it. The interest rate at which the company could raise a medium-term loan is 10% per annum before tax. The company tax rate is 30%. If the asset is leased, a rental of $51 000 will be payable yearly in advance for 7 years. Assume that tax is in the same year. Should the company purchase or lease the device? (Round all discount rates to the nearest whole percentage). QUESTION 4 A firm can either lease or purchase a $50 000 asset. The firm depreciates assets via straightline, and the asset under consideration has a five-year normal recovery period. The firm’s tax rate is 30% and its before-tax cost of borrowing is 10%. If leased, the five annual lease payments are payable in advance. At what lease payment (rounded to the nearest dollar) is the firm indifferent between leasing and purchasing the asset? Assume tax is in the same year. QUESTION 5 Allpine Limited owns the building and land that comprises its head office. The building has a remaining life of 20 years, is being depreciated by the straightline method, and has a book value of $1.1 million. The land has a book value of $500 000. At the end of the 20 years, it is expected that the building will be demolished at a cost of $100 000 and the vacant land sold for $1 million. The Lease-All Company Limited has offered to pay Allpine Ltd $1.6 million for the land and building, and grant it a 20-year lease at $200 000 per year, payable yearly in advance. Allpine would pay for maintenance, insurance and municipal rates. It would have no right or interest in the property at the expiration of the lease. The taxation laws do not allow depreciation of the building to be claimed as a deduction, but lease payments would be deductible for Allpine Ltd. The company tax rate is expected to remain at 30% over the next 20 years and Allpine expects to earn a profit in each of those years. Its after-tax opportunity cost of funds is 8% per annum. Assuming tax is payable in the same year and there is no tax on the salvage value in Year 20, should Allpine enter into the sale-and-lease back agreement with the Lease-All Company Ltd?
FIN2101 BUSINESS FINANCE II SOLUTIONS TO TUTORIAL QUESTIONS moduLe 8- ANALYSIS OF LEASES
September 2003 FIN2101 BUSINESS FINANCE II SOLUTIONS TO TUTORIAL QUESTIONS MODULE 8 - ANALYSIS OF LEASES
QUESTION 1 Initial After-tax DTS A-tax PVIFs Present Outlay Lease Foregone a 10%Values Avoided Payments Value Flows Foregone 030000(63000 237000 237000 (13500) 76500)0.909(69539 63000(13500 (76500) 0.826(63189) 63000 (13500) (76500)0.751(57452) (63000)(13500 (765000683(52250) (13500)(57500)(710000621(44091) NPV=-$49521 Borrow and Purchase Working After-tax Lease payments Before-tax Lease Payments x(1-D =S90000(1-0.3) 63000 Depreciation Tax Savings Annual Depreciation Expense X T (S300000×0.15)×0.3 $45000×0.3 $13500 Salvage value WDB.V $75000 Salvage value 50000 $25000 Tax Savings on loss $25000×0.3 Salvage value $50000 Tax Savings on loss 7500 Salvage Value Foregone $57 500
September 2003 QUESTION 1 t Initial Outlay Avoided After-tax Lease Payments DTS Foregone A-tax Salvage Value Foregone Net Cash Flows PVIFs @ 10% Present Values 0 300 000 (63 000) 237 000 1 237 000 1 (63 000) (13 500) (76 500) 0.909 (69 539) 2 (63 000) (13 500) (76 500) 0.826 (63 189) 3 (63 000) (13 500) (76 500) 0.751 (57 452) 4 (63 000) (13 500) (76 500) 0.683 (52 250) 5 (13 500) (57 500) (71 000) 0.621 (44 091) NPV = -$49 521 Borrow and Purchase Workings After-tax Lease Payments = Before-tax Lease Payments ×(1 - T) = $90 000 (1 - 0.3) = $63 000 Depreciation Tax Savings = Annual Depreciation Expense ×T = ($300 000 ×0.15) ×0.3 = $45 000 ×0.3 = $13 500 Salvage Value W.D.B.V. $75 000 Salvage Value 50 000 Loss on Disposal $25 000 Tax Savings on Loss = $25 000 ×0.3 = $7 500 Salvage Value $50 000 Tax Savings on Loss 7 500 Salvage Value Foregone $57 500
QUESTION 1(Continued) Alternative solution NPV=S2300(76500 PVIFA10)-(700PⅤIE10) =-$2300-($7600×3.17($7000k0.62 =-$23T00$24205$44091 4996 NPV is negative. therefore the firm should BORROW AND PURCHASE Another alternative solution Students may choose to calculate separate NPVs for each of the purchase and lease alternatives hase s30000(13500 k P,210)+(s5700PⅥIE10.) =-S30000+(S13500×379)+(S575000.62川 =-$30000+$579$35708 s21313 NPV S6000(s63000PVIF Ao) S630-($6300317 s63000$19910 s26210 Choose to BORROW AND PURCHASE(better off by $49 597)
September 2003 QUESTION 1 (Continued) Alternative Solution ( ) ( ) ( ) ( ) - $49596 - $237000- $242505- $44091 - $237000- $76500 3 .1 7 0- $71000 0 .6 2 1 NP V - $237000- $76500 P VIF A0. 10, 4 - $71000 P VIF0. 10, 5 = = = = NPV is negative, therefore the firm should BORROW AND PURCHASE. Another Alternative Solution Students may choose to calculate separate NPVs for each of the purchase and lease alternatives. ( ) ( ) ( ) ( ) - $ 2 1 3113 - $ 3 0 0000 $51179 $35708 - $ 3 0 0000 $13500 3 .7 9 1 $57500 0 .6 2 1 NP VPu r c ha s e - $ 3 0 0000 $13500 P VIF A0 . 1 0 , 5 $57500 P VIF0 . 1 0 , 5 = = + + = + + = + + ( ) ( ) - $ 2 6 2710 - $63000- $ 1 9 9710 - $63000- $63000 3 .1 7 0 NP VLe a s e - $63000- $63000 P VIF A0. 10, 4 = = = = Choose to BORROW AND PURCHASE (better off by $49 597)
QUESTION 2 A-tax DTS A-tax PVIFs Present Salva Cash Payments Value Flows oregon o85000(7700 77300 7700) (10250)0926(9492) (7700)(25 (102500857(8784) (7700(25 (7700) 2550) (10250)0735(7534) (2550 (102500681(6980 (77 2550 (10250)0630(6458 (7700)(2550 (10250)0583(5976) (7700) 2550) (10250)0540(5535) (7700)_(2550) (10250)0500(5125) 10 (250)(3500)(6050)0463(2801) NPV=$10476 Lea Working tax lPs=B- tax lp×(-T) 1D00k(1-0.30 7700 S=An n u alDep =$2550 A-tax Sv=B-taxSVx(1-T) (1-0.30 $3500 Disco un trate=b tofDebtx(l-T) 0.08r8%
September 2003 QUESTION 2 t Initial Outlay Avoided A-tax Lease Payments DTS Foregone A-tax Salvage Value Foregone Net Cash Flows PVIFs @ 8% Present Values 0 85000 (7 700) 77300 1 77300 1 (7 700) (2550) (10250) 0.926 (9492) 2 (7 700) (2550) (10250) 0.857 (8784) 3 (7 700) (2550) (10250) 0.794 (8139) 4 (7 700) (2550) (10250) 0.735 (7534) 5 (7 700) (2550) (10250) 0.681 (6980) 6 (7 700) (2550) (10250) 0.630 (6458) 7 (7 700) (2550) (10250) 0.583 (5976) 8 (7 700) (2550) (10250) 0.540 (5535) 9 (7 700) (2550) (10250) 0.500 (5125) 10 (2550) (3500) (6050) 0.463 (2801) NPV = $10 476 Lease Workings ( ) ( ) $ 77 0 0 $ 1 10 0 0 1- 0 .3 0 A - tax LPs B- tax LP 1- T = = = ( ) $ 25 5 0 $ 8 50 0 0 1 0 0 .3 0 DT S An n u alDep reciati o n Ex p en se T = = = ( ) ( ) $ 35 0 0 $ 50 0 0 1- 0 .3 0 A - tax S V B- tax S V 1- T = = = ( ) ( ) 0 .0 8o r 8 % 0 .1 1 4 3 1- 0 .3 0 Disco u n t Rate B- tax Co st o f Deb t 1-T = = =
QUESTION 2(Continued) Alternative solution NPV=$7700(s1050PVFA3)-(86050PVIE2os. 7700(10506.24S6050k0.46B $7700$64032s2801 NPV is positive, therefore the firm should LEase Another alternative solution NPVPurchas = -$8 5000+(S 25 5OPVIF A, 08. 1)+(s PViFo $8500($2550k6.71+(3500k0.46 $85000+S171H$1621 66268 NPVease=-$7700(S770OPVIF Ao =-$700(S7700×6.24y =-$7700$4802 $5s02 Choose to LEASE(better off by $10 466)
September 2003 QUESTION 2 (Continued) Alternative Solution ( ) ( ) ( ) ( ) - $10467 $77300- $64032- $ 2801 $77300- $10250 6 .2 4 7- $ 6050 0 .4 6 3 NP V $77300- $10250 P VIF A0. 08, 9- $ 6050 P VIF0. 08, 10 = = = = NPV is positive, therefore the firm should LEASE. Another Alternative Solution ( ) ( ) ( ) ( ) - $ 6 62 6 8 - $ 8 50 0 0 $ 1 71 1 1 $ 16 2 1 - $ 8 50 0 0 $ 25 5 0 6 .7 1 0 $ 35 0 0 0 .4 6 3 NP VPur c ha s e - $ 8 50 0 0 $ 25 5 0 P VIF A0. 0 8, 10 $ 35 0 0 P VIF0. 0 8, 10 = = + + = + + = + + ( ) ( ) - $ 5 58 0 2 - $ 77 0 0- $ 4 81 0 2 - $ 77 0 0- $ 77 0 0 6 .2 4 7 NP VLe a s e - $ 77 0 0- $ 77 0 0 P VIF A0 . 0 8 , 9 = = = = Choose to LEASE (better off by $10 466)
QUESTION 3 Initial A-tax DTS PVIFs Present Outlay Lease Foregone @7%Values Avoided Payments Flows 30000(35700 264300 264300 012345 35700(18000(537000935(50210)1 357001[(18000(537000873[(4680)1 35700(18000(537000816〖(43819) (35700(18000(537000.763(40973) 35700(180004537000713(38288) (35700 (35700)066(23776) NPV=$20354 Working A-tax LPs=B-tax LPx1-T 5D00k(1-0.30 =$35700 DTS= An nu alD 30⑩000.20×0.30 Note that the machine is fully depreciated after 5 years. Discoun tRate=B-tax Co stof(I-T) 0.07r7%
September 2003 QUESTION 3 t Initial Outlay Avoided A-tax Lease Payments DTS Foregone Net Cash Flows PVIFs @ 7% Present Values 0 300 000 (35 700) 264 300 1 264 300 1 (35 700) (18 000) (53 700) 0.935 (50 210) 2 (35 700) (18 000) (53 700) 0.873 (46 880) 3 (35 700) (18 000) (53 700) 0.816 (43 819) 4 (35 700) (18 000) (53 700) 0.763 (40 973) 5 (35 700) (18 000) (53 700) 0.713 (38 288) 6 (35 700) (35 700) 0.666 (23 776) NPV = $20 354 Lease Workings ( ) ( ) $ 3 57 0 0 $ 5 10 0 0 1- 0 .3 0 A - tax LPs B- tax LP 1- T = = = ( ) $ 1 80 0 0 $ 3 0 00 0 0 0 .2 0 0 .3 0 DT S An n u alDep reciati o n Ex p en se T = = = Note that the machine is fully depreciated after 5 years. ( ) ( ) 0 .0 7o r 7 % 0 .1 0 1- 0 .3 0 Disco u n t Rate B- tax Co st o f Deb t 1-T = = =
QUESTION 3(Continued) Alternative solution NPV=S26400(53700 X VIFA20)-(s35700xPⅤH.an) 26400($53700×4.10($35700×0.665 26400$22070$2376 20B54 NPV is positive, therefore the firm should LEASE Another alternative solution NPVpurchas=-$ 30000+(S 1 VIF A,.7) =-S30000+(180004.10 -S30⑩00+$7300 s22600 NPV s35700(35700 P VIFA2 S35700-(S35700476 35700$17082 20882 Choose to LEASE(better off by $20 318)
September 2003 QUESTION 3 (Continued) Alternative Solution ( ) ( ) ( ) ( ) $ 2 03 5 4 $ 2 6 43 0 0- $ 2 2 01 7 0- $ 2 37 7 6 $ 2 6 43 0 0- $ 5 37 0 0 4 .1 0 0- $ 3 57 0 0 0 .6 6 6 NP V $ 2 6 43 0 0- $ 5 37 0 0 P VIF A0. 0 7, 5 - $ 3 57 0 0 P VIF0. 0 7, 6 = = = = NPV is positive, therefore the firm should LEASE. Another Alternative Solution ( ) ( ) - $226200 - $300000 $73800 - $300000 $18000 4 .1 0 0 NP VPur c ha s e - $300000 $18000 P VIF A0. 07, 5 = = + = + = + ( ) ( ) - $ 2 0 5882 - $35700- $ 1 7 0182 - $35700- $35700 4 .7 6 7 NP VLe a s e - $35700- $35700 P VIF A0. 07, 6 = = = = Choose to LEASE (better off by $20 318)
QUESTION 4 Step 1- Calculate the Pv of the cash flows from ownership PV=S5000450000 0.3× PVIF A.07 $5000+($3000×4.10 =-$5000+$12300 37700 Step 2-Calculate minimum after-tax LPs $3700LP+LPX PVIF A o7, s37700=LP+3.38ZP 3700=4.387P LP=S8593.57 Step 3-Calculate minimum before-tax LPs LP 1-T 1-0.30 12276.5
September 2003 QUESTION 4 Step 1 – Calculate the PV of the cash flows from ownership ( ) - $37700 - $50000 $12300 - $50000 $ 3000 4 .1 0 0 0 .3 0 P VIF A 5 $50000 P V - $50000 0 . 0 7 , 5 = = + = + = + Step 2 – Calculate minimum after-tax LPs ( ) $ 85 9 3 .5 7 $ 3 77 0 0 4 .3 8 7 $ 3 77 0 0 3 .3 8 7 $ 3 77 0 0 P VIF A0 . 07 , 4 = = = + = + L P L P L P L P L P L P Step 3 – Calculate minimum before-tax LPs $ 1 22 7 6 . 5 3 1 - 0 . 3 0 $ 85 9 3 . 5 7 1 - T L P L P A -t a x B-t a x = = =
