4. The lessee's lease analysis

Consider the case of Shoe Building Inc. (SBI):

Shoe Building Inc. (SBI) is considering the purchase of new manufacturing equipment that will cost $35,000 (including shipping and installation). SBI can take out a four-year, $35,000 loan to pay for the equipment at an interest rate of 8.40%. The loan and purchase agreements will also contain the following provisions:

The annual maintenance expense for the equipment is expected to be $350.

The equipment has a four-year depreciable life. The Modified Accelerated Cost Recovery System's (MACRS) depreciation rates for a three-year asset are 33.33%, 44.45%, 14.81%, and 7.41%, respectively.

The corporate tax rate for SBI is 40%.

Note: Shoe Building Inc. (SBI) is allowed to take a full-year depreciation tax-saving deduction in the first year.

Based on the preceding information, complete the following tables:

QUESTION:

Annual tax savings from maintenance will be:

A. $294

B. $140

C. $154

D. $63

QUESTION:

Tax savings from depreciation

YEAR 1

A. 20,999

B. 17,219

C. 4,666

D. 6,300

YEAR 2

A. 13,999

B. 6,223

C. 20,999

D. 4,666

YEAR 3

A. 2,073

B. 17,219

C. 1,037

D. 6,300

YEAR 4

A. 1,037

B. 20,999

C. 17,219

D. 6,300

QUESTION:

NET CASH FLOW:

YEAR 1

A. 52,213

B. 4,456

C. - 76,784

D. 9,214

YEAR 2

A. 9,214

B. - 76,784

C. 6,013

D. 52,213

YEAR 3

A. 1,863

B. - 76,784

C. 9,214

D. 52,213

YEAR 4

A. 9,214

B. 827

C. 52,213

D. - 76,784

QUESTION:

Thus, the net present value (NPV) cost of owning the asset will be:

A. -$50,213

B. -$22,520

C. -$23,022

D. $27,854

Shoe Building Inc. (SBI) has been offered an operating lease on the same equipment. The four-year lease requires end-of-year payments of $1,400, and the firm will have the option to buy the asset in four years for $7,700. The firm will want to use the equipment longer than four years, so it plans to exercise this option. All maintenance will be provided by the lessor.

QUESTION: What is the NPV cost of leasing the asset?

A. -$9,301

B. -$32,714

C. -$2,286

D. -$11,626

QUESTION:

Should SBI lease or buy the equipment?

A. Buy

B. Lease