Question

XYZ Storage is evaluating a project which involves producing a new product with an extended marketable life of 4 years. To produce this product, the company will have to acquire a piece of new equipment worth $400,000. The company is considering whether it should lease or borrow to purchase the equipment. The opportunity cost of borrowing for an asset which has a purchase price of $400,000 is 15% p.a. Other details of each alternative are provided as follows:

Purchase:
This equipment can be depreciated at 20% reducing balance if owned, and has an expected salvage value of $100,000 after 4 years.
Lease:
If the lease is in advance, there will be four payments of $145,000 made at the beginning of each year and a residual payment of $40,000 made at the end of the term, i.e., at the end of year 4.
The company tax rate is 25%. Calculate the NPV of leasing and advise the company as to whether it should purchase or lease the equipment with payments made in advance?

Answer 1

To advise XYZ Storage on whether to lease or purchase equipment, the NPV for both options needs to be calculated by factoring in depreciation, salvage value, lease and residual payments, opportunity cost of capital, and tax implications.

Step-by-step explanation:

To evaluate whether XYZ Storage should lease or purchase equipment worth $400,000, we need to calculate the net present value (NPV) for both options, taking into account the opportunity cost, tax implications, and expected cash flows over the project's life.For the purchase option, the equipment will be depreciated at a 20% reducing balance, and there is an expected salvage value of $100,000 at the end of 4 years. The cost of borrowing is 15% per annum. Tax benefits from depreciation and interest expense must be considered in the NPV calculation.

For the leasing option, there will be four annual lease payments of $145,000, with each payment made at the beginning of the year, and a residual payment of $40,000 at the end of year 4. Tax savings from lease payments need to be included in the NPV calculation for this option.The NPV for each option will include all cash outflows and inflows, discounted at the borrowing cost of 15%. These will then be compared to determine which option is more financially advantageous for the company, considering the tax rate of 25%.