Question 4 (18 marks)

Shell Corporation is a garment manufacturer and is considering installing a sewing machine for $3,800,000. The machine will depreciate straight-line over three years and will have zero salvage value.

Shell Corporation can alternatively lease the machine from Royal Leasing. The annual lease payment is $1,600,000 per year, payable at the end of each of the three years of the lease.

Royal Leasing can borrow at 6% and Shell Corporation can borrow at 10%. The corporate tax rate is 30%.

(a) Should Shell Corporation buy or lease the sewing machine? (Show your calculations). (7 marks)

(b) What is the maximum lease payment that would be acceptable to Shell Corporation? (Show your calculations). (4 marks)

(c) Suppose Royal Leasing's tax rate is unchanged, but Shell Corporation has a tax rate of 15%. Calculate the range of lease payments with positive NPV for both firms. (Show your calculations). (7 marks)