Kohers Inc is considering a leasing arrangement to finance some manufacturing tools that it needs for the next 3 years. The tools will be obsolete and worthless after 3 years. The firm will depreciate the cost of the tools on a straight-line basis over their 3 year life. It can borrow $4,800,000, the purchase price, at 10% and buy the tools, or it can make 3 equal end-of-year lease payments of $2,100,000 each and lease them. The loan obtained from the bank is a 3-year simple interest loan, with interest paid at the end of the year. The firm's tax rate is 40%. Annual maintenance costs associated with ownership are estimated at $240,000 but this cost would be borne by the lessor if it leases. What is the net advantage to leasing(NAL), in thousands?

Question

Kohers Inc is considering a leasing arrangement to finance some manufacturing tools that it needs for the next 3 years. The tools will be obsolete and worthless after 3 years. The firm will depreciate the cost of the tools on a straight-line basis over their 3 year life. It can borrow $4,800,000, the purchase price, at 10% and buy the tools, or it can make 3 equal end-of-year lease payments of $2,100,000 each and lease them. The loan obtained from the bank is a 3-year simple interest loan, with interest paid at the end of the year. The firm's tax rate is 40%. Annual maintenance costs associated with ownership are estimated at $240,000 but this cost would be borne by the lessor if it leases. What is the net advantage to leasing(NAL), in thousands?
(Suggestion:Delete 3 zeros from dollars and work in thousands)

Bot · Answer

To calculate the Net Advantage to Leasing (NAL), we need to compare the present value of the after-tax cash outflows under each option (leasing vs. buying).

Option 1: Leasing
- Annual lease payment (after-tax) = $2,100,000 * (1-0.4) = $1,260,000
- Since there are no maintenance costs for leasing, the total after-tax cash outflows during the 3-year period will be only the lease payments.
Present value of leasing (PV of leasing) = $1,260,000 + $1,260,000 / (1.1)^1 + $1,260,000 / (1.1)^2 = $1,260,000 + $1,140,909 + $1,036,281 = $3,437,190

Option 2: Buying
- The loan amount is $4,800,000
- The loan interest (end of each year) = 10% * $4,800,000 = $480,000
- After-tax loan interest payment = $480,000 * (1-0.4) = $288,000
- The annual depreciation expense for the tools (Straight-line method) = $4,800,000 / 3 = $1,600,000
- The tax shield on depreciation = $1,600,000 * 0.4 = $640,000
- Annual maintenance costs (after tax) = $240,000 * (1-0.4) = $144,000

Let's calculate the present value for buying, which is the sum of after-tax loan payments, maintenance costs, and tax savings on depreciation, all adjusted for the time value of money.

PV of Loan interest payments = $288,000 + $288,000 / (1.1)^1 +$288,000 / (1.1)^2 = $288,000 + $261,818 + $238,017 = $787,835

PV of Maintenance costs = $144,000 + $144,000 / (1.1)^1 + $144,000 / (1.1)^2 = $144,000 + $130,909 + $119,008 = $393,917

PV of Tax shield on depreciation = $640,000 + $640,000 / (1.1)^1 + $640,000 / (1.1)^2 = $640,000 + $581,818 + $529,108 = $1,750,926

Now, we will calculate the present value of buying (PV of buying) by adding up the PV of Loan interest payments, PV of Maintenance costs, and deducting the PV of Tax shield on depreciation.

PV of buying = $787,835 + $393,917 - $1,750,926 = $430,826

Now, let's calculate the net advantage to leasing (NAL) by subtracting the present value of buying from the present value of leasing.

NAL = PV of leasing - PV of buying = $3,437,190 - $430,826 = $3,006,364

So, the net advantage to leasing (NAL) is $3,006,364 in thousands.