Meyer Retirement (Again) Company (MRC) is evaluating the merits of leasing versus purchasing a truck with a 4-year life that costs $75,000 and falls into the MACRS 3-year class. If the firm borrows and buys the truck, the loan rate would be 6%, and the loan would be amortized over the truck's 4-year life, so the interest expense for taxes would decline over time. The loan payments would be made at the end of each year. The truck will be used for 4 years, at the end of which time it will be sold at an estimated residual value of $20,000. If MRC buys the truck, it would purchase a maintenance contract that costs $1,500 per year, payable at the beginning of each year. The lease terms, which include maintenance, call for a $18,000 lease payment (4 payments total) at the beginning of each year. MRC's tax rate is 21%. What is the net advantage to leasing? (Note: Assume MACRS rates for Years 1 to 4 are 0.3333, 0.4445, 0.15, and 0.07 respectively and round all dollars to the nearest whole number.)

 

Net advantage to Leasing = 1400

Step-by-step explanation

1) Net Present Value for Lease Option

After tax interest rate = Interest rate * (1- tax rate)

After tax interest rate = 6%*(1-21%) = 4.74%

Net Present Value for Lease = Lease Payments * (1-tax rate) * (1-(1+r)^-n)/r * (1+r)

Net Present Value for Lease = 18000 * (1-21%) * (1-(1+4.74%)^-4)/4.74% * (1+4.74%)

Net Present Value for Lease = 53134.02

2) Net Present Value for BUY Option

i) After tax interest rate = Interest rate * (1- tax rate)

After tax interest rate = 6%*(1-21%) = 4.74%

ii) Present value of annual Depreciation tax shields = Cost * Depreciation rate * tax rate / (1+After tax interest rate)^n

Year 1 = (75000*0.3333*21%)/(1+4.74%)^1 = 5011.91

Year 2 = (75000*0.4445*21%)/(1+4.74%)^2 = 6381.56

Year 3 = (75000*0.15*21%)/(1+4.74%)^3 = 2056.05

Year 4 = (75000*0.07*21%)/(1+4.74%)^4 = 916.07

Total Present value of Depreciation tax shields = 5011.91 + 6381.56 + 2056.05 + 916.07 = 14365.60

iii) Present value of annual Maintenance = Annual maintenance expenses*(1-tax rate) * (1-(1+r)^-n)/r

Present value of annual Maintenance = 1500*(1-21%) * (1-(1+4.74%)^-4)/4.74% = 4227.45

iv) Present value of After tax residual value

After tax residual value = 20000*(1-21%) = 15800

Present value of After tax residual value = 15800 / (1+4.74%)^4 = 13128.25

v) Net Present value of cost Buy option = Purchase Price - Total Present value of Depreciation tax shields + Present value of annual Maintenance - Present value of After tax residual value

Net Present value of cost of Buy option = 75000 - 14365.60 + 4227.45 - 13128.25 = 51733.60

So total Outflow in present value term = 51733.60

3) Net advantage of Leasing

Net advantage of Leasing = Net Present Value for Lease - Net Present value of cost of Buy option

Net advantage of Leasing = 53134.02 - 51733.60 = 1400.42 Or 1400