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

Question

a) The machinery fall s into the MACRS-3year class
b)Under either the lease or the purchase, Big Sky must pay for the insurance, property taxes and maintenance
c) The firm's tax rate is 40%
d) The loan would have an interest rate of 15%
e) The lease terms call for $400,00 payments at the end of each the next 4 years
f) Assume that Big Sky Mining has no use for the machine beyond expiration of the lease. The machine has an estimated residual value of $250,000 at the end of the year.
Determine:
a. Should the equipment be leased or purchased?

Before proceeding with our NPV analysis we must determine the schedule of depreciation charges for this new equipment.


MACRS 3-year Depreciation Schedule
Year 1 2 3 4
Depr. Rate
Depr. Exp.
Tax Shield


We can now construct our table of incremental cash flows from these two alternatives. Remember, that the appropriate discount rate in this scenario is the after tax cost of borrowing, or: 15%*(1-40%) = 9%.


NPV LEASE ANALYSIS OF INCREMENTAL CASH FLOWS

Cost of ownership Year = 0 1 2 3 4

Loan proceeds
Purchase cost

Interest payments
Tax Shield
After-tax interest payment
Principal payment

Tax savings from depreciation

Annual Cost Savings
Tax on Savings
After-tax Cost Savings

Salvage value
Taxes on salvage value
Net cash flow from ownership
PV cost of ownership

Cost of leasing
Annual lease payments
Tax Shield
After-tax Lease Payments

Annual Cost Savings
Tax on Savings
After-tax Cost Savings
Net cash flow from leasing
PV cost of leasing

Cost Comparison
PV ownership cost @ 9%
PV of leasing @ 9%
Net Advantage to Leasing