Precision Tool is trying to decide whether to lease or buy some new equipment for its tool and die operations. The equipment costs $52,000, has a 3-year life and will be worthless after the 3 years. The pre-tax cost of borrowed funds is 10 percent and the tax rate is 33 percent. The equipment can be leased for $18,500 a year. What is the net advantage to leasing? (Do not round intermediate calculations.)

$4,200

Explanation:

Cost of equipment = $52,000

Life of equipment = 3 years

Depreciation through straight line method = 52,000/3 = $17,333

Tax rate = 33%

Pretax cost of debt = 10%

Lease amount of equipment = $18,500

After tax cost of debt = 10%*(1-0.33)

After tax cost of debt = 10%*(0.67)

After tax cost of debt = 0.067

After tax cost of debt = 6.7%

After tax lease payment amount = 18,500*(1-0.33)

After tax lease payment amount = 18,500*0.67

After tax lease payment amount = 12,395

Present Value of 3 lease payment = 12,395/(1+0.067) + 12,395/(1+0.067)^2 + 12,395/(1+0.067)^3

Present Value of 3 lease payment = 12395/1.067 + 12395/1.1385 + 12395/1.2148

Present Value of 3 lease payment = 11616.68 + 10887.13 + 10203.33

Present Value of 3 lease payment = $32,707.14

Present Value of cost involved in purchasing the equipment is $52,000, however there will be a tax shield from depreciation therefore, this amount would reduce the company's cost.

Annual depreciation tax shield = 17,333*0.33 = $5719.89. There will be tax shield on depreciation for 3 years. Therefore, present value of $5719.89 is calculated for three years:

= $5719.89/(1+0.067) + $5719.89/(1+0.067)^2 + $5719.89/(1+0.067)^3

= $5719.89/1.067 + $5719.89/1.1385 + $5719.89/1.2148

= $5360.72 + $5024.06 + $4708.50

= $15,093.28

Present Value of the cost of buying the equipment = $52,000 - $15,093.28 = $36,906.72

Net Advantage Leasing = Present Value of the cost of buying the equipment - Present Value of 3 lease payment

Net Advantage Leasing = $36,906.72 - $32,707.14

Net Advantage Leasing = $4,199.58

Net Advantage Leasing = $4,200.

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