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St. Martin's Hospital plans to purchase or lease a $2 million CT scanner. If purchased, the CT scanner will be depreciated on a straight-line basis over five years, after which it will be worthless. If leased, the annual lease payments will be $500,000 per year for five years. St. Martin's borrowing cost is 8%, and its tax rate is 35%.
-Should St. Martin lease the scanner or borrow the funds and buy the scanner?
A) Buy the scanner; the NPV of the decision = $74,890.28.
B) Buy the scanner; the NPV of the decision = $1,749,890.28
C) Lease the scanner; the NPV of the decision = $1,812,027.19
D) Lease the scanner; the NPV of the decision = $692,559.51

Question

Quizplus · Accepted Answer

A) First we construct the FCF from leasing and buying. The FCF from leasing are the annual lease payments × (1 - τ_c) since these payments are deductible for tax purposes. The FCF from buying represents the original cost of the purchase in year 0 and the depreciation tax shield of ($2 million / 5 years) × .35. The free cash flows are as follows: 11ea84dc_f4a7_a417_9a63_2bf329f96e29_TB1316_00_TB1316_00 The NPV is the cash flows discounted at the after tax borrowing rate (.08)(1 - .35) = .052 or 5.2%. NPV = 1,675,000 - 11ea84dc_f4a7_a418_9a63_937445c8dde9_TB1316_11_TB1316_11 - 11ea84dc_f4a7_a419_9a63_b763f25a1986_TB1316_11_TB1316_11 - 11ea84dc_f4a7_a41a_9a63_4916c90c56e2_TB1316_11_TB1316_11 - 11ea84dc_f4a7_cb2b_9a63_b3fc2090076c_TB1316_11_TB1316_11 - 11ea84dc_f4a7_cb2c_9a63_dde0fe3a920f_TB1316_11_TB1316_11 = $74,890

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