Business & Finance

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

Solution: