ABC Inc. is contemplating on two options of either buying or leasing of an Equipment that has a negotiated price of Br20 M. the equipment is expected to last five years in use and be salvageable for Br2 m at the end of its economic life. The depreciation policy of the firm is Straight line and applicable yearly and consistently. When the equipment is Leased, the lessor expects br7.5 m/year of rent. ABC Inc. is in 30% tax bracket, and capable of borrowing at 16%.

 

Instruction: Evaluate lease vs buying and advise management of ABC Inc. which one of the two is worth considering.

 

Answer:

After tax cost of borrowing = 16%*(1-30%) = 11.20%

After tax lease rentals = 7.5 m/year * (1-0.3) = 5.25 m/year

So, PV of after tax lease rentals (net cost of leasing)

= 5.25/0.112*(1-1/1.112^5) = Br19.31 m (assuming end of year lease rentals)

In purchase, ABC inc can avail of Depreciation tax benefits as well as salvage value

Depreciation each year = (20m-2m)/5 = 3.6 m/year

Tax benefit on Depreciation =3.6 m *0.3 =1.08 m/year

PV of Depreciation tax benefit = 1.08/0.112*(1-1/1.112^5) = Br 3.97 m

PV of Salvage value = 2m/1.112^5 = Br 1.1762 m

So, net cost under Purchase/Buying option = Br 20m - Br 3.97 M - Br 1.1762 M = Br14.85 m

As the net cost of Buying is much lesser than the net cost of Leasing, ABC Inc should consider buying the equipment