3.What typically happens to the leased equipment after the term of the leaseexpires?
After the term of the lease expires the leased equipment is typically leased out again(in case of an operating lease) or sold in the used market. Its fate depends on thetype of equipment, technological developments in the field, as well as the economicand financial conditions of the market.
4.After doing all the calculations, Paulo realizes that he underestimated thecost savings that would result from improved efficiency by $1000 per year.How should this error be handled? Is it relevant? Explain.
As can be seen from the cash flows in #2 above, cost savings are irrelevant in thecase of lease versus purchase decisions since they would benefit both alternativesleaving a net advantage of zero.
5.How should depreciation and taxes be accounted for in the calculations?
Depreciation is a tax write-off available to the owner. It results in a tax savingequal to the annual depreciation charge times the corporate tax rate of the owner.When the equipment is leased, therefore, the lessee loses the depreciation tax shield.Taxes must be adjusted for when calculating the salvage value (if any), the lease payments, and any operating cost savings. The analysis must be done net of taxes.2
Lease Versus BuyYear 0Year 1Year 2Year 3Year 4Year 5LEASEAfter-tax Lease Payment=25000(1-T)($15,000)($15,000)($15,000)($15,000)($15,000)Lost Depreciation tax shield=Dep(T)($13,332)($17,776)($5,928)($2,964)$ -Maintenance cost saving=Maint.Cost(1-T)$1,200$1,200$1,200$1,200$1,200Avoidance of upfront cost$100,000Loss of after-tax salvage value in year 5($18,000)Total Cash flows of leasing versus buying$100,000($27,132)($31,576)($19,728)($16,764)($31,800)Cost of Lease8.70%After-tax cost of borrowing6%DECISION
BORROW AND BUY
Note: The cost savings and buy option ($40,000) would be irrelevant