Purchase Area Telecom (PAT) is independently owned and operates in the area west of the Land between the Lakes region in the Western Kentucky. The company provides cellular service to customers in several adjacent communities, and it works with other companies to provide cellular services to customers in remote areas. In recent years, the population of the area served by the company had grown rapidly. Because of this growth, company personnel and equipment had been hard pressed to meet the demands for building and maintaining new cellular equipment. For a time, the company had used an outside contractor to handle overload work, but several poor experiences had caused abandonment of that practice. It was obvious that the company needed a significant upgrade in various aspects of its cellular network.

The need to upgrade its facilities arose at a critical period for the company. PAT has already made heavy commitments to purchase equipment needed to improve service. Recent payments for new equipment had strained the working capital position of the firm. Stockholders were unable to provide additional resources and hoped to avoid issuing additional shares which would dilute their ownership. The interest rates were quoted at 6%, but it hoped to avoid unnecessary borrowing since it had been earning only about 8.5% on its net assets (this can also be assumed to be its current weighted average cost of capital)

During the summer Meagan Foreman, general manager of PAT, requested bids for the cellular equipment from four dealers. The lowest bid received was from Reliable Technologies, which quoted a total cash price of $45,000,000. If purchased, the equipment would be depreciated as a five-year asset following the MACRS methodology. The equipment was expected to last for five years, at which time it could probably be sold for about $8,000,000. (Note that it would not be fully depreciated after five years so there would be capital gains taxes to consider). As an alternative, Reliable would lease the equipment to PAT for five years with the first years cost being $17,500,000 and subsequent lease payments growing at 3% per year. If the equipment were leased, PAT would have to pay the annual lease charge on or before the first day of each year. In addition, it would be responsible for all operating and maintenance costs, like those incurred if it owned the equipment, except for software upgrades, which Reliable would provide . The cost of upgrading the software, an expense PAT would face if it purchased the equipment outright, would be $12,000,000 with the first payment expected at the end of the second year of operations with future upgrade costs rising at 5% per year. (For simplicity, assume the annual upgrade costs would be made at the end of each year).

Ms. Foreman was unsure how to view the alternatives presented by Reliable Technologies. Leasing the equipment would reduce the immediate demands on PATs financial resources. Still, the prospect of paying nearly $93,000,000 over five years when the equipment could be purchased new for $45,000,000 raised questions about how well she would be serving company stockholders if she recommended leasing rather than purchasing the equipment. On the other hand, the operating expenses and lease payments would be allowable expense deductions in calculating income for tax purposes. The company had been paying and is expected to continue to pay a tax rate of 24%.

Please complete all the calculations in excel.

A. What is the cost differential between buying and leasing the assets (in NPV terms) and would you recommend the company buy or lease the new equipment?

B. Redo your analysis by assuming that all cash flows (the cost of software upgrades, operating cost tax benefits, and depreciation tax benefits) are expected to occur or accrue evenly throughout the years (use the mid-year approximation formula). The lone exceptions are the lease payments, made at the beginning of each year, and the equipment purchase and salvage values, made at time 0 and received at the end of Year 5, respectively. Given these new assumptions, what is the cost differential between buying and leasing the assets and would you now recommend buying or leasing the assets?