15-7
Loan/cost 130,000 Residual value 0 Maxit
Lease payment 32,000 Before-tax cash flows 48,000
Tax rate 28% WACC 11%
Depreciation deduction 20% After-tax cost of debt 7%
NPV 0 1 2 3 4 5
Cost -130,000
After-tax cash flows 34,560 34,560 34,560 34,560 34,560
Depreciation tax saving 7,280 7,280 7,280 7,280 7,280
-130,000 41,840 41,840 41,840 41,840 41,840
PV Factor 1.0000 0.9009 0.8116 0.7312 0.6587 0.5935
-130,000 37,694 33,958 30,593 27,561 24,830
NPV 24,636
Conclusion: Maxit Ltd should invest in the equipment as the NPV is positive.
The discount rate to evaluate the project is the WACC.
The next step is to evaluate whether the company should purchase or lease the equipment.
Leasing 0 1 2 3 4 5
Lease payment -32,000 -32,000 -32,000 -32,000 -32,000
Tax saving 8,960 8,960 8,960 8,960 8,960
-32,000 -23,040 -23,040 -23,040 -23,040 8,960
PV Factor 1.0000 0.9346 0.8734 0.8163 0.7629 0.7130
-32,000 -21,533 -20,124 -18,808 -17,577 6,388
Net Present Cost -103,653
Purchase 0 1 2 3 4 5
PV of Loan -130,000
Depreciation tax saving 7,280 7,280 7,280 7,280 7,280
Residual value 0
Recoupment tax 0
-130,000 7,280 7,280 7,280 7,280 7,280
PV Factor 1.0000 0.9346 0.8734 0.8163 0.7629 0.7130
-130,000 6,804 6,359 5,943 5,554 5,191
Net Present Cost -100,151
Conclusion: XYZ should finance the acquisition with a loan. The company should not lease the asset.
Note: Although a company may not borrow to purchase, by leasing the company is using up its debt capacity.
This means that we are evaluating the lease vs purchase alternatives by discounting at the after-tax cost of
debt as leasing is similar to debt.
Workings
Cost 130,000
Depreciation - total -26,000 5 -130,000
Tax value 0
Residual value 0
Recoupment 0
Tax 0
Cost Rate Depreciation Tax rate Tax saving
Depreciation tax saving 130,000 20% 26,000 28% 7,280
Before-tax 1-tax rate After-tax
After tax Cash Flows 48,000 72% 34,560
15-14
Loan/cost 2,400,000 Residual value 1,400,000
Lease payment 480,000 Maintenance 120,000
Tax rate 28% Depreciation deduction 10%
Before-tax cost of debt 9.722% Depreciation deduction - from end of lease 20%
After-tax cost of debt 7.000%
a. Sanele Fishing
Leasing 0 1 2 3 4 5
Lease payment -480,000 -480,000 -480,000 -480,000 -480,000
Acquisition at end of lease -1,400,000
PV of depreciation deductions 321,455
Tax saving 134,400 134,400 134,400 134,400 134,400
-480,000 -345,600 -345,600 -345,600 -345,600 -944,145
PV Factor 1.0000 0.9346 0.8734 0.8163 0.7629 0.7130
-480,000 -322,991 -301,860 -282,113 -263,657 -673,162
Net Present Cost -2,323,782
Borrowing 0 1 2 3 4 5
PV of Loan -2,400,000
Depreciation tax saving 67,200 67,200 67,200 67,200 67,200
Maintenance cost, after tax -86,400 -86,400 -86,400 -86,400 -86,400
PV of depreciation deductions 275,533
-2,400,000 -19,200 -19,200 -19,200 -19,200 256,333
PV Factor 1.0000 0.9346 0.8734 0.8163 0.7629 0.7130
-2,400,000 -17,944 -16,770 -15,673 -14,648 182,762
Net Present Cost -2,282,272
Net Advantage of Leasing -41,510
PV of depreciation tax shields
A B AxB
Depreciation -1,400,000 20% -280,000
Depreciation tax shields -280,000 28% -78,400
Tax shield PVFA (formula) PV
PV of depreciation tax shields -78,400 4.100197 -321,455
Depreciation tax shields 240,000 28% 67,200
Tax shield PVFA (formula) PV
PV of depreciation tax shields 67,200 4.100197 275,533
Note:
The residual value at the end of 10 years is not relevant as it applies to both options.
The maintenance expenses after year 5 is not relevant as it is applicable to both options.
b.
As leasing is an alternative to debt and the cash flows are relatively certain, the discount rate should be the
after tax cost of debt. However, the future residual value of the fishing vessel will be highly variable and it can
be argued that for such risky cash flows, the discount rate should reflect the cost of capital.