Question

Your firm is considering leasing a new laser light. The lease lasts for 3 years. The lease calls for 4 before-tax payments of $12,000 per year with the first payment occurring immediately.

The computer would cost $45,000 to buy and would be straight-line depreciated to a zero salvage value over 3 years. The first depreciation will be recorded in year 1. The firm would not want the laser light after three years. The market value is 0 at the end of three years. The firm's WACC is 20%. The firm will take a new loan at an interest rate of 10% to finance the purchase if they decide to own the machinery. First interest payment would start at the end of first year and be paid annually after that.
The corporate tax rate is 40%.
What is the appropriate discount rate for valuing the lease vs owning after-tax CFs?

Answer 1

The appropriate discount rate is the after-tax WACC of 20%.

Step-by-step explanation:

The appropriate discount rate for valuing the lease versus owning after-tax cash flows is the after-tax Weighted Average Cost of Capital (WACC) of 20%. The WACC takes into consideration the cost of financing and the risk associated with the investment. Since the lease payments and the after-tax cash flows from owning the machinery are in different time periods, it is important to use a common discount rate to compare the two options. Considering the WACC as the appropriate discount rate ensures a consistent evaluation of the lease versus ownership decision.