Carnival Company is considering leasing a new equipment The

Carnival Company is considering leasing a new equipment. The lease lasts for 8 years. The lease calls for 8 payments of $9,000 per year with the first payment occurring immediately. The equipment would cost $60,000 to buy and would be straight-line depreciated to a zero salvage value over 8 years. The actual salvage value is negligible because of technological obsolescence. The firm can borrow at a rate of 6%. The corporate tax rate is 25%. What is the NPV of the lease relative to the purchase? $6,276.51 $4,729.61 -$3,519.26 -$2,537.00 -$1,556.47

Solution

Answer : When they buy the equipment then ,

Assume that borrowed amount is paying as equally annual principal payments and installments are started from year 0.

Equal Principal amount will be : 60000/8 = 7500 p.a.

Here the P.V. Factor will be Interest(1-tax rate) = 6(1-0.25) = 4.5%

Depriciation on equipment = 60000/8 = 7500 p.a.

(1)

End of Year

(2)

Principal

(3)

Interest @ 6%

(4)

Principal Balance

(5)

Depriciation

(6)

Tax sheild [(3)+(5)]*25%

(7)

Cash Outflow [(2)+(3)]-(6)

(8)

P.V.Factors @ 4.5%

(9)

PV (7)*(8)

Hence , Net Cash outflow when company will buy the equipment 47635.21 $

When company will take equipment on lease

(1)

End of the year

(2)

Lease Payment

(3)

Tax sheild

(2)*25%

(4)

Cash outflow

(5)

PVIFA@4.5%

(6)

PV = (4)*(5)

Hence , Cash outflow on leasing an equipment will be 47196 $

Therefore , cash outflow in leasing is lower then buying , so , company should lease the equipment.