Recovery Centers of America needs to acquire new vehicles that will cost $2.5 million across its six state service area.

It plans to use the vehicles for three years, at which time new vehicles will be acquired. The company can obtain a 3.49 percent bank loan to buy

the vehicles or it can lease the vehicles for three years. Assume that the following facts apply to the decision:

- The vehicles fall into the five-year class for tax depreciation, so the MACRS allowances are 0.2, 0.32, 0.19, 0.12, 0.11, and 0.06 in Years 1 through 6, respectively.

- The company's marginal tax rate is 28 percent.

- Tentative lease terms call for payments of $550,000 at the end of each year.

- The best estimate for the value of the vehicles after three years of wear and tear is $1,350,000.

Tax Rate

Year

Allowance

28%

1

20%

2

32%

a. What is the NAL and IRR of the lease?

3

19%

b. Should the organization buy or lease the equipment?

4

12%

5

11%

6

6%

Year 0

Year 1

Year 2

Year 3

Cost of owning:

Net purchase price

Depreciation tax savings

Residual value

Tax on residual value

Net cash flow

Cost of leasing:

Lease payment

Tax savings from lease

Net cash flow

Net advantage to leasing:

Before Tax Cost of Debt (BTCD)

PV cost of leasing

3.49%

PV cost of owning

-

a.

NAL

After Tax Cost of Debt (ATCD)

2.51%

Internal rate of return of the lease:

Leasing cash flow

Owning cash flow

Incremental cash flow

IRR

b.