Tutorial 8

Question 1 (Handwritten)
The Hybee Company is evaluating an investment to produce a new product with an
expected marketable life of 5 years. The expected annual net cash flow before tax is
$120 000. To produce this product the company will have to acquire new plant. The
company can either purchase this plant or lease it. Details of these alternatives are as
follows:

Purchase
- The purchase price of the plant is $250 000 and it is expected that it will have
a zero residual value after 5 years. The allowable annual depreciation charge
on the plant is 20 per cent per annum, straight-line.

Lease
- The lease requires five annual payments, each of $60 000, payable at the
beginning of each year. The company tax rate is 30 cents in the dollar. The
required rate of return on the investment is 15 per cent per annum after tax
and the after-tax cost of an equivalent loan is 8 per cent per annum.

Should the company undertake the investment? If so, should it purchase or lease the
plant?

First, evaluate the investment.

After-tax net cash flow = $120 000(1 − 0.3) + $50 000  0.3
= $99 000 per annum
$99 000  1 
NPV = −$250 000 + 1−

(0.15)  (1.15) 5 
= $81 863
Therefore, the investment is profitable.

Second, determine whether to lease or purchase the plant.

The incremental net cash flows for leasing versus purchasing are as follows:

Year

0 1 2 3 4 5

Cost of plant ($) 250 000

Lease rentals ($) −60 000 −60 000 −60 000 −60 000 −60 000
Tax savings on lease
rentals ($) 18 000 18 000 18 000 18 000 18 000
Depreciation tax
savings lost ($) −15 000 −15 000 −15 000 −15 000 −15 000

Total ($) 208 000 −57 000 −57 000 −57 000 −57 000 −15 000

$57 000  1  $15 000

NPV = $208 000 − 1− −

(0.08)  (1.08) 4  (1.08) 5
= $9000, which means that the lease is financially attractive.

Therefore, the investment should proceed and the plant should be leased.
 Question 2 (Handwritten)
You are an analyst employed to evaluate a financial lease relating to a piece of
machinery. You are provided with the following information:

Purchase price of machinery $200,000

Useful life of machinery 5 years
Corporate tax rate 30%
Net operating cash flows (before tax) $70,000
produced by the machine at the end of
each year
Required rate of return from the 17% p.a.
machine itself (after tax)
Cost of debt capital used to purchase 9% p.a.
the machine (before tax)

The company accountant tells you the asset will be fully depreciated over its useful
life and will have zero residual value. You are also told that the machine is integral to
a project that management has already decided the company will proceed with.

(a) What is the maximum lease payment that the company should be willing to
pay?

(b) If the lease payment required was greater than the amount documented in (a)
what would be your advice to the company?

(a)
Time 0 1 2 3 4 5
Initial cost $200,000
Depreciation -$12,000 -$12,000 -$12,000 -$12,000 -$12,000
tax shield
Lease payment -L -L -L -L -L
Lease payment +0.3L +0.3L +0.3L +0.3L +0.3L
tax shield

Depreciation tax shield = 0.3*(200000/5) = $12,000 p.a.

After tax discount rate = 0.09(1-0.3) = 6.3% p.a.
 $12,000 1 0.7𝐿 1
𝑁𝑃𝑉 = 0 = +200,000 − [1 − ] − 0.7𝐿 − [1 − ]
0.063 (1.063)5 0.063 (1.063)4

0 = +200,000 − 50,138.48 − 3.109𝐿

𝐿 = $48,202.42

(b)
We would advise them not to lease that they would be better off borrowing to buy
the asset.
Question 3 (Excel)
Tasty Pies is expanding its business and wants to open a new facility to make frozen
pies, which requires a new automated pie maker. One such pie maker can be
purchased for $300,000. Alternatively, it can be leased for $52,000 per year for seven
years and lease rentals need to be paid annually in advance. The management
informs you that the new pie maker can be fully depreciated to zero using the
straight-line method over four years and that its scrap/residual value is expected to
be $5,000 at the end of the lease. Tasty Pies has estimated that the appropriate after-
tax opportunity cost of capital of the expansion is 19% per annum, and the net
present value of the expansion is expected to $10,000.

Tasty Pies pays tax at the rate of 30% and it can borrow funds at a before-tax rate of
11% per annum. All cash-flows have been quoted on a before-tax basis. Would you
recommend that Tasty Pies buy or lease the pie maker? What is the incremental
wealth associated with your decision?
Question 4 (Excel)
Pinder Ltd needs to use a truck for its operations. The truck costs $180,000 and is
expected to last for 8 years. The salvage value of the truck at the end of the 8 years is
expected to be $15,250. Pinder Ltd has an effective tax rate of 30% and the before-
tax cost of borrowing is 10% per annum. If purchasing the truck, Pinder Ltd will use a
straight-line depreciation method for taxation purposes and will fully depreciate it.
Pinder Ltd has the option of borrowing-to-buy the truck or to lease the truck, where
the lease payment would be due in advance each year. What is the maximum annual
lease payment that Pinder Ltd would be willing to pay?

Description 0 1 2 3 4 5 6 7 8
Cost 180000
Lease Payment -L -L -L -L -L -L -L -L
Tax Shield 0.3L 0.3L 0.3L 0.3L 0.3L 0.3L 0.3L 0.3L
Depreciation Tax Shield -6750 -6750 -6750 -6750 -6750 -6750 -6750 -6750
Residual -15250
Tax on Gain/Loss 4575
Total 180000-0.7L -6750-0.7L-6750-0.7L-6750-0.7L-6750-0.7L-6750-0.7L-6750-0.7L-6750-0.7L -17425

After tax cost of borrowing 0.07

Pre-Disount
Cash 180000 -6750 -6750 -6750 -6750 -6750 -6750 -6750 -17425
L -0.7 -0.7 -0.7 -0.7 -0.7 -0.7 -0.7 -0.7

Discounted
180000 -6308.41 -5895.71 -5510.01 -5149.54 -4812.66 -4497.81 -4203.56 -10141.5
-0.7 -0.65421 -0.61141 -0.57141 -0.53403 -0.49909 -0.46644 -0.43592 0

Sum Cash 133480.788

Sum L -4.47250258
L 29844.7649
Pinder Ltd would be willing to pay up to $29,844.76