Big Sky Mining Company

1) Big Sky Mining Company must install $1.5 million of new machinery in its Nevada mine. It can obtain a bank loan for 100% of the purchase price, or it can lease the machinery. Assume that the following facts apply:
1. The machinery falls into the MACRS 3-year class.
2. Under either the lease or the purchase, Big Sky must pay for insurance, property taxes, and maintenance.
3. The firm’s tax rate is 40%.
4. The loan would have an interest rate of 15%.
5. The lease terms call for $400,000 payments at the end of each of the next 4 years.
6. Big Sky Mining has no use for the machine beyond the expiration of the lease, and the machine has an estimated residual value of $250,000 at the end of the 4th year.
What is the NAL (Net Advantage of Leasing) of the lease?

You would have cash flows for owning and leasing in years 1-4. You should also have tax on residual value in year 4 in cost of owning.

NPV LEASE ANALYSIS

Year = 0 1 2 3 4
Cost of Owning
After-tax loan payments ($135,000)($135,000) ($135,000) ($1,635,000)
Maintenance Cost
Tax savings from main.
Tax savings from depr. $198,000 $270,000 $90,000 $42,000
Residual value $250,000
Tax on residual value
Net cash flow $0 $63,000 $135,000 ($45,000) ($1,443,000)
PV ownership cost @ 9% $ (885,580.87)
Cost of Leasing
Lease payment(AT) ($240,000) ($240,000) ($240,000) ($240,000)
Net cash flow $0 ($240,000) ($240,000) ($240,000) ($240,000)
PV of leasing @ 6.5% $ (777,532.77)

Cost Comparison
PV ownership cost @ 9% $ (885,580.87)
PV of leasing @9% $ (777,532.77)
Net Advantage to Leasing $ 108,048.10
2) Net advantage to leasing problem (NAL).
ABC Industries is negotiating a lease on a new piece of equipment which would cost $100,000 if purchased. The equipment falls into the MACRS 3-year class, and it would be used for three years and then sold, because ABC plans to move to a new facility at that time. It is estimated that the equipment could be sold for $30,000 after three years of use. A maintenance contract on the equipment would cost $3,000 per year, payable at the beginning of each of the three years of usage. Conversely, ABC could lease the equipment for three years for a lease payment of $29,000 per year, payable at the beginning of each year. The lease would also include maintenance. ABC is in the 20 percent tax bracket, and it could obtain a three-year simple interest loan to purchase the equipment at a before tax cost of 10 percent. Should ABC lease or buy?

NPV LEASE ANALYSIS

Year = 0 1 2 3
Cost of Owning
After-tax loan payments ($8,000) ($8,000) ($108,000)
Maintenance Cost (after tax) ($2,400) ($2,400) ($2,400) $0
Depreciation $33,000 $45,000 $15,000
Tax savings from depr. $6,600 $9,000 $3,000
Residual value $30,000
Tax on residual value ($4,600)
Net cash flow ($2,400) ($3,800) ($1,400) ($79,600)
PV ownership cost @ 8% $ (70,307.84)

Cost of Leasing
Lease payment $29,000 $29,000 $29,000 $0
Tax savings from leas($5,800) ($5,800) ($5,800) $0
Net cash flow $23,200 $23,200 $23,200 $0
PV of leasing @ 8% $ 64,571.74

Cost Comparison
PV ownership cost @ 8% $ (70,307.84)
PV of leasing @ 8% $ 64,571.74
Net Advantage to Leasing $ (5,736.10)