Lease Financing

Use the following information to answer the next two questions:

Torpedo Arms Company must install $1.5 million of new machinery in its Arizona production site. It can obtain a bank loan for 100% of the purchase price, or it can lease the machinery. Assume that the following facts apply:

- The machinery falls into the MACRS 3-year class.

- Under the purchase, Torpedo must pay for maintenance of $20,000 at the beginning of each year.

- The firms tax rate is 40%.

- The loan would have an interest rate of 15%.

- The lease terms call for $475,000 payments at the end of each of the next 4 years.

- The machine has an estimated residual value of $250,000 at the end of the 4th year.

1. (EXCEL TEMPLATE) Should Torpedo lease or buy? What is the Net Advantage to leasing?

2. (EXCEL TEMPLATE) What is the maximum lease payment that would be acceptable to Torpedo?

1 Equip Cost 2 3 Depr. Rate 4 AT Loan Payment 5 Maintenance 6 Depr Tax Shield 4 ATSV 8 Total Cash Flow 9 10 NPV-Owning 12 13 Lease Pmt 14 Tax Savings 15 Total Cash Flow 16 NPV-Leasing 18 NAL of Lease What is the maximum lease payment that Torpedo would be willing to pay? 20 21 22 23 Hint: After tax cash flows of leasing need to have the same NPV as owning Use the NPV of owning as the PV in a payment calculation Solve for Payment (PMT) 25 26 The payment amount that you just calculated is on an AFTER TAX basis, so find the BEFORE 27 28 29 30 Lease Pmt 31 Tax Savings 32 Total Cash Flow 33 NPV-Leasing 34 The NPV of leasing in cell B33 should be the same number as cell B10 above 35 TAX amount and place it in the Lease Pmt box below 4 1 Equip Cost 2 3 Depr. Rate 4 AT Loan Payment 5 Maintenance 6 Depr Tax Shield 4 ATSV 8 Total Cash Flow 9 10 NPV-Owning 12 13 Lease Pmt 14 Tax Savings 15 Total Cash Flow 16 NPV-Leasing 18 NAL of Lease What is the maximum lease payment that Torpedo would be willing to pay? 20 21 22 23 Hint: After tax cash flows of leasing need to have the same NPV as owning Use the NPV of owning as the PV in a payment calculation Solve for Payment (PMT) 25 26 The payment amount that you just calculated is on an AFTER TAX basis, so find the BEFORE 27 28 29 30 Lease Pmt 31 Tax Savings 32 Total Cash Flow 33 NPV-Leasing 34 The NPV of leasing in cell B33 should be the same number as cell B10 above 35 TAX amount and place it in the Lease Pmt box below 4