Lease versus buy decisions abound in the aviation industry. Examples include whether to lease or buy...
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Lease versus buy decisions abound in the aviation industry. Examples include whether to lease or buy an aircraft or machinery. The evaluation process is similar regardless of the purpose and focuses on analyzing the cash flows associated with each decision. The total cash flows are examined on an after-tax basis and converted to their present value. Often maintenance costs are borne by the lessor which may make the leasing decision more favorable to the company. Tax considerations are important as well because the owner of the equipment can depreciate the asset, while the lessor cannot. After computing the present value of the total cash outflows, choose the alternative with the lower present value of cash outflows as it will be the least-cost financing alternative. Instructions The problem below allows you to demonstrate your understanding of these concepts. Time to Fly Company needs to expand its facilities. To do so, the firm must acquire a machine costing $80,000. The machine can be leased or purchased. The firm is in the 25% tax bracket, and its after-tax cost of debt is 9%. The terms of the lease and purchase plans are as follows: Lease. The leasing arrangement requires end-of-year payments of $19,800 over 5 years. All maintenance costs will be paid by the lessor; insurance and other costs will be borne by the lessee. The lessee will exercise its option to purchase the asset for $24,000 at the termination of the lease. Purchase. If the firm purchases the machine, its cost of $80,000 will be financed with a 5-year, 10% loan requiring equal end-of-year payments. The machine will be depreciated under MACRS using a 5-year recovery period (depreciation rates of 20%, 32%, 19%, 12%, and 12%, respectively). The firm will pay $2,000 per year for a service contract that covers all maintenance costs; insurance and other costs will be borne by the firm. The firm plans to keep the equipment and use it beyond its 5-year recovery period. (Hint: solve for the annual end-of-year loan payment first.) 1. Determine the after-tax cash outflows of Time to Fly Corporation under each alternative. 2. Find the present value of each after-tax cash outflow stream, using the after-tax cost of debt (9%) as your discount rate. 3. Which alternative-lease or purchase-would you recommend? Why? An illustrative example of how you can set up your work is below-note this setup is merely an example only and not required. 1. Determine After-Tax Cash Outflows for Lease and Purchase Lease After-tax cash outflows = Annual Lease* (1- tax rate) = x/year for 5 years plus purchase option amount in year 5 (year 5 totals the annual loan payment plus the purchase option amount). Purchase Illustrative Example After-tax Cash Outflows Purchase Table Loan Interest Maintenance Depreciation Year Payment at x% (2) (3) (1) (4) Total Deductions (2+3+4) (5) Tax Shields [(Tax rate) (5)] (6) After-Tax Cash Outflows [(1+2)-(6)] (7) 1 N 3 < 5 2. Present Value of Cash Outflows Analysis Present Value of Cash Outflows Analysis Table 1 2 3 4 5 End of Year Present value of cash outflows at x% discount rate 3. Select alternative and explain why. Lease After-Tax Cash Outflows Purchase After-Tax Cash Outflows Lease versus buy decisions abound in the aviation industry. Examples include whether to lease or buy an aircraft or machinery. The evaluation process is similar regardless of the purpose and focuses on analyzing the cash flows associated with each decision. The total cash flows are examined on an after-tax basis and converted to their present value. Often maintenance costs are borne by the lessor which may make the leasing decision more favorable to the company. Tax considerations are important as well because the owner of the equipment can depreciate the asset, while the lessor cannot. After computing the present value of the total cash outflows, choose the alternative with the lower present value of cash outflows as it will be the least-cost financing alternative. Instructions The problem below allows you to demonstrate your understanding of these concepts. Time to Fly Company needs to expand its facilities. To do so, the firm must acquire a machine costing $80,000. The machine can be leased or purchased. The firm is in the 25% tax bracket, and its after-tax cost of debt is 9%. The terms of the lease and purchase plans are as follows: Lease. The leasing arrangement requires end-of-year payments of $19,800 over 5 years. All maintenance costs will be paid by the lessor; insurance and other costs will be borne by the lessee. The lessee will exercise its option to purchase the asset for $24,000 at the termination of the lease. Purchase. If the firm purchases the machine, its cost of $80,000 will be financed with a 5-year, 10% loan requiring equal end-of-year payments. The machine will be depreciated under MACRS using a 5-year recovery period (depreciation rates of 20%, 32%, 19%, 12%, and 12%, respectively). The firm will pay $2,000 per year for a service contract that covers all maintenance costs; insurance and other costs will be borne by the firm. The firm plans to keep the equipment and use it beyond its 5-year recovery period. (Hint: solve for the annual end-of-year loan payment first.) 1. Determine the after-tax cash outflows of Time to Fly Corporation under each alternative. 2. Find the present value of each after-tax cash outflow stream, using the after-tax cost of debt (9%) as your discount rate. 3. Which alternative-lease or purchase-would you recommend? Why? An illustrative example of how you can set up your work is below-note this setup is merely an example only and not required. 1. Determine After-Tax Cash Outflows for Lease and Purchase Lease After-tax cash outflows = Annual Lease* (1- tax rate) = x/year for 5 years plus purchase option amount in year 5 (year 5 totals the annual loan payment plus the purchase option amount). Purchase Illustrative Example After-tax Cash Outflows Purchase Table Loan Interest Maintenance Depreciation Year Payment at x% (2) (3) (1) (4) Total Deductions (2+3+4) (5) Tax Shields [(Tax rate) (5)] (6) After-Tax Cash Outflows [(1+2)-(6)] (7) 1 N 3 < 5 2. Present Value of Cash Outflows Analysis Present Value of Cash Outflows Analysis Table 1 2 3 4 5 End of Year Present value of cash outflows at x% discount rate 3. Select alternative and explain why. Lease After-Tax Cash Outflows Purchase After-Tax Cash Outflows
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