Question

GNL company wants to invest $5,000,000 in trucks but wishes to evaluate whether leasing is worthwhile. GNL drivers are very hard on their trucks such that they are worn out and have no residual value at the end of ten years. Armstrong Leasing has offered to lease the vehicles over a ten-year term for $500,000 per year. The company may also borrow the necessary funds using a ten-year term loan with an interest rate of 10%. Ignore the issue of insurance, maintenance, and other costs of ownership. If GNL buys the trucks outright, they will be able to claim CCA each year at 30% and obtain a corresponding tax shield of 40%. The UCCA for year one is 50% of the assets. Assume a discount rate of 5%.

a. Should the company lease or buy the assets? Explain with details.
b. Would you advise GNL company to buy or lease when the annual lease amount is $600,000? Justify why or why not.

Answer 1

The decision whether GNL company should lease or buy trucks can be made by comparing the present value of lease payments to the net present value of purchasing the trucks, taking into account the tax shield from CCA and the cost of borrowing at a 10% interest rate, with a discount rate of 5% applied to both options.

Step-by-step explanation:

The question at hand involves a financial analysis to determine whether the GNL company should lease or buy trucks for their operations, considering specific costs and benefits associated with each option, such as lease payments, interest rates on a term loan, and tax shields available through Capital Cost Allowance (CCA). Since the trucks have no residual value at the end of ten years and a tax shield on CCA is available when purchasing, a comparison of the present value of both options using the given discount rate is necessary to advise the company appropriately.

For the lease option, the company would pay $500,000 annually over ten years. To evaluate this option, we need to calculate the present value of these lease payments using the 5% discount rate. Conversely, for the buy option, the initial investment is $5,000,000, and though there is a 10% interest rate on the term loan, there is also a 40% tax shield on the CCA, which is 30% for the first year and declines subsequently. The initial year has a 50% UCCA rate. Net present value calculations would factor in these savings over the ten-year period.

Comparing the present value of the lease payments to the present value of buying (after accounting for tax shields and cost of borrowing) will allow the company to see which option is more cost-effective. If leasing results in a lower present value, leasing is the better option; otherwise, buying would be preferable. In the case where the lease amount is $600,000 annually, the analysis would similarly follow, with the new lease payments being evaluated against the purchase option.