Annual lease payment (1st payment due when the lease is signed)$71 500CCA rate 30% Company's borrowing rate 10% Company's tax rate 40% Company's cost of capital 6.5% Investment Tax Credit Rate 10%New Brunswick Salmon Farms has asked for your opinion on whether to lease or purchase this asset. What should you say?
A) It does not matter whether New Brunswick Salmon Farms leases it or purchases it - the company would be equally well off either way
B) New Brunswick Salmon Farms would be better off by leasing it
C) New Brunswick Salmon Farms would be better off by purchasing it
D) There is insufficient information to determine which option would be better for New Brunswick Salmon Farms

Question

Quizplus · Accepted Answer

The first step is to calculate the net present value (NPV) of leasing and purchasing options separately. For leasing, the NPV can be calculated using the formula:

NPV = present value of lease payments - present value of tax savings - present value of investment tax credit

Using the given information, the present value of lease payments is $71,500, the present value of tax savings is $11,440 ($71,500 x 40% x 6.5%), and the present value of investment tax credit is $7,150 ($71,500 x 10%). Therefore, the NPV of leasing is:

NPV = $71,500 - $11,440 - $7,150 = $52,910

For purchasing, the NPV can be calculated using the formula:

NPV = present value of cash outflow - present value of tax savings + present value of salvage value

The present value of cash outflow is the purchase price of the asset, which can be calculated using the CCA rate:

Purchase price = $71,500 / (1 + 30%) = $55,000

The present value of tax savings is $8,030 ($55,000 x 40% x 6.5%), and the present value of salvage value is $22,000 ($55,000 x 40%). Therefore, the NPV of purchasing is:

NPV = -$55,000 + $8,030 + $22,000 = -$24,970

Since the NPV of leasing is positive while the NPV of purchasing is negative, it is clear that New Brunswick Salmon Farms would be better off by leasing the asset. Therefore, the answer is C.

Annual Lease Payment (1st Payment Due When the Lease Is