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.)

Question

Quizplus · Accepted Answer

First, let's calculate the after-tax cost of borrowing $4,800,000 at 10% for 3 years:
Interest expense per year = $4,800,000 × 10% = $480,000
After-tax interest expense per year = $480,000 × (1 - 0.4) = $288,000
Total after-tax interest expense for 3 years = $288,000 × 3 = $864,000
Total cost of ownership = $4,800,000 + $240,000 × 3 + $864,000 = $6,984,000

Now, let's calculate the present value of the lease payments:
PV of lease payments = $2,100,000 + $2,100,000/(1+10%) + $2,100,000/(1+10%)^2 = $5,297,520

The NAL can be calculated as follows:
NAL = PV of lease payments - Total cost of ownership
NAL = $5,297,520 - $6,984,000 = -$1,686,480

Since the NAL is negative, it means that leasing is more expensive than owning. Therefore, the best choice is to buy the tools by borrowing from the bank.