Whistle Farms is considering either leasing or buying some new equipment. The lessor will charge $16,000 a year for a 3-year lease. The purchase price is $46,000. The equipment has a 3-year life after which time it will be worthless. Whistle Farms uses straight-line depreciation, has a 35 percent tax rate, borrows money at 9 percent, and has sufficient tax loss carryovers to offset any potential taxable income the firm might have over the next five years. What is the net advantage to leasing?

Question

Quizplus · Accepted Answer

The net advantage to leasing (NAL) can be calculated by comparing the cost of leasing to the cost of buying. 1. **Leasing Costs:** The total leasing cost over 3 years is straightforward: $16,000 * 3 = $48,000.2. **Buying Costs:** When buying, the company can deduct depreciation from its taxable income, reducing its tax liability. The purchase price is $46,000, and with straight-line depreciation over 3 years, the annual depreciation expense is $46,000 / 3 = $15,333.33. The tax shield from depreciation is $15,333.33 * 35% = $5,366.67 per year. Over 3 years, the total tax shield is $5,366.67 * 3 = $16,100. The after-tax cost of buying is the purchase price minus the total tax shield: $46,000 - $16,100 = $29,900.3. **Cost of Borrowing:** Since the company borrows at 9%, the cost of borrowing $46,000 over 3 years needs to be considered. The after-tax cost of debt is the interest expense less the tax shield on the interest. For simplicity, if we consider the interest expense on $46,000 at 9% per year, it's $4,140 per year. The after-tax cost of this interest is $4,140 * (1 - 35%) = $2,691 per year. Over 3 years, this adds up to $2,691 * 3 = $8,073.4. **Total Buying Cost:** Adding the after-tax cost of borrowing to the after-tax cost of buying gives the total cost of buying: $29,900 + $8,073 = $37,973.5. **Net Advantage to Leasing (NAL):** The NAL is the difference between the leasing costs and the total buying costs: $48,000 - $37,973 = $10,027.However, the calculation provided does not directly match any of the options given, indicating a mistake in the step-by-step explanation. The correct approach to calculate NAL involves comparing the present value of leasing costs to the present value of owning costs, taking into account tax savings from depreciation and the cost of capital. The correct answer (C) $5,499, suggests a miscalculation in the explanation provided. The correct calculation involves more detailed present value analysis, considering the tax benefits and cost savings over time, discounted back at the company's cost of capital or borrowing rate. My explanation mistakenly oversimplified the calculation without accurately accounting for the time value of money and the specific tax implications over the lease versus buy period.

Whistle Farms Is Considering Either Leasing or Buying Some New