Question

Precision Tool is trying to decide whether to lease or buy some new equipment for its tool and die operations. The equipment costs $1.2 million has a 7-year life, and will be worthless after the 7 years. The pre-tax cost of borrowed funds is 8 percent and the tax rate is 32 percent. The equipment can be leased for $242,500 a year. What is the value of the lease? Should the firm purchase the asset via debt-financing or sign a long-term financial lease agreement?

Answer 1

-$51,566.

Step-by-step explanation:

So, we are given the following parameters in the question above;

Cost of equipment = $1.2 million, pre-tax cost of borrowed funds = 8 percent, tax rate = 32 percent and the equipment can be leased for = $242,500 a year.

Step one : Calculate the After-Tax lease payment .

The After-Tax lease payment = ($242,500) × (1 - 0.32) = $164,900.

Step two: Calculate the Annual Depreciation Tax-Shield.

Annual Depreciation Tax-Shield = ($1,200,000/7) × (0.32) = $54,857.

Step three: Calculate the After-Tax Discount Rate.

The After-Tax Discount Rate = 0.08 × (1 - 0.32) = 5.44%.

Step four: Calculate the Net Advantage to Leasing.

The Net Advantage to Leasing = $1,200,000 - ($164,900 + $54,857.14) × (PVIFA 5.44%, 7).

= -$51,566