My students of FIN 427 (Corporate Finance II). Hope you are all in good health.

I am uploading
this handout to explain the solution to the demonstration problem on lease financing.

Let us first review the problem question

1. Anderson plans to acquire automated assembly line equipment with a 10-year life and
a cost of $10 million, delivered and installed. However, Anderson plans to use the
equipment for only five years, for it will discontinue the product line at that time.
2. Anderson can borrow the required $10 million at a before-tax cost of 10 percent.
3. The equipment’s estimated scrap value is $50,000 after 10 years of use, but its
salvage value after five years of use is $1 million.
4. Anderson can lease the equipment for five years at a rental charge of $2.75 million
per year payable at the beginning of each year, but the lessor will own the equipment
upon expiration of the lease.
5. The lease contract stipulates that the lessor will maintain the equipment at no
additional charge to Anderson. However, if Anderson borrows and buys, it will have
to bear the cost of maintenance, which will be performed by the equipment
manufacturer at a fixed contract rate of $500,000 per year payable at the beginning of
each year. The maintenance cost to Anderson is tax deductible.
6. The equipment falls under the MACRS 5-year class life. Anderson’s marginal tax rate
is 40 percent and the lease qualifies for a guideline lease.

Should Anderson lease or buy the assembly line equipment? Make your decision based on the
NPV and IRR analyses.
LESSEE’S ANALYSIS

After reading the question, your first task is to find out the life of the lease. Refer to the problem
statement 1. The equipment has a 10 years life, but Anderson will use the asset for five years. So
Anderson will enter in a lease contract with the lessor for 5 years. There cash flows from the
lease will be generated for 5 years (years 0, 1, 2, 3, 4, 5, and 6)

…………………………….. Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Cash flows from Leasing

Let us now find out the cash flows for the lessee that will result from leasing.
Refer to problem statement 4. Anderson can lease the equipment for five years at an annual
charge of $2.75 million per year payable at the beginning of each year. Furthermore problem
statement 5 states that the cost of maintenance shall be borne by the lessor. So Anderson does not
pay for maintenance if it leases the equipment. There the only cash flows relevant to Anderson as
lessee are:

1. Annual lease payment of $2.75 million, payable at the beginning of each year.
2. Tax savings resulting from lease payments at a 40 percent tax rate (problem statement 6)

Cash flow calculations always assume end-of-year cash flows. Therefore, the beginning-of-year
cash flows have to be treated as end-of-year cash flows for the previous year. Thus year 1
beginning-of- year cash flow will be treated as beginning-of-year for year 0, year 2 beginning-
of- year cash flow will be treated as beginning-of-year for year 1, and so forth.

Therefore, Anderson’s cash flows from leasing can be shown as follows:

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Leasing
Lease Payment – $2,750,000 – $2,750,000 – $2,750,000 – $2,750,000 – $2,750,000
Payment tax saving + 1,100,000 + 1,100,000 + 1,100,000 + 1,100,000 + 1,100,000
Net cash flow (NCF L) – $1,650,000 – $1,650,000 – $1,650,000 – $1,650,000 – $1,650,000

Cash flows from Buying

Let us now see what Anderson’s cash flows would be if it bought the equipment instead of
leasing.

1. Anderson has to buy the equipment in year 0 spending $10 million.

2. Anderson, as the owner and user of the equipment has to pay the maintenance cost of
$500,000 per year, payable at the beginning of each year. (years 1 through 4)
3. According to the last sentence of problem statement 5, the maintenance cost is tax deductible.
4. Anderson, as the owner of the equipment, shall charge depreciation on the equipment and
shall be entitled to receive tax savings there on. Problem statement 6 states that the
equipment falls under MACRS 5-year class. The equipment shall be depreciated at 20%,
32%, 19%, 12%, and 12% for years 1 through 5 respectively. Note that depreciation charges
are always end-of-year, not beginning.

Depreciat Depreciation Tax savings

Year
ion rate charge @ 40%
1 20% 2,000,000 800,000
2 32% 3,200,000 1,280,000
3 19% 1,900,000 760,000
4 12% 1,200,000 480,000
5 12% 1,200,000 480,000
5. After 5 years (end of year 5), Anderson will dispose of the equipment at $1,000,000.
However, after 5 years of use, Anderson will have depreciated 95% of the equipment’s value.
The equipment’s book value after five years shall be 5% of the equipments acquisition cost
of $10,000,000, i.e., 0.05*$10,000,000 = $500,000. This will give Anderson a gain of
$500,000 from the disposal of the equipment, which is taxable.

Salvage value: $1,000,000

Book value: 500,000
Gain: $ 500,000
Tax on sale @ 40% $ 200,000

Therefore, Anderson’s cash flows from buying can be shown as follows:

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Buying
Cost of Equipment – $10,000,000
Maintenance cost – 500,000 –$ 500,000 –$500,000 –$500,000 –$500,000
Maintenance tax savings + 200,000 + 2,00,000 + 200,000 + 200,000 + 200,000
Depreciation tax savings + 800,000 +1,280,000 + 760,000 + 480,000 + 480,000
Salvage value $ 1,000,000
Tax effect on sale - 200,000
Net cash flow (NCFB) -$ 10,300,000 $ 500,000 $ 980,000 $ 460,000 $180,000 $ 1,2800,000

Incremental Net Cash Flow (NCFL – NCFB)

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Net cash flow from Lease (NCFL) -$1,650,000 -$1,650,000 -$1,650,000 -$1,650,000 -$1,650,000
Net cash flow from Buy (NCFB) -$10,300,000 $500,000 $980,000 $460,000 $180,000 $1,280,000
Incremental NCF (NCFL - NCFB ) $8,650,000 -$2,150,000 -$2,630,000 -$2,110,000 -$1,830,000 -$1,280,000

Net Advantage to Lease (NAL)

The next task is to calculate Net Advantage to Lease (NAL). NAL is the net present value of
incremental NCFs when the Lessee’s after tax cost of borrowing is used to calculate the present
values. You may remember from your FIN 301 (or FIN 421) class that the after tax cost of debt
is the before tax cost minus tax.

kDAT = kDBT(1 – T)

According to problem statement 2, Anderson can borrow the entire cost of the equipment at a
before tax cost of 10%. Therefore, the after tax cost of borrowing = 10%(1 – 0.4) = 6%.

NAL can be calculated in two ways:

1. Calculate the net present value of incremental net cash flows.

NAL = NPV of NCL – NCFB
2. a. Calculate NPV of NCFL, b. calculate NPV of NCFB, c. NAL = NPVL – NPVB
1. NAL = NPV of NCL – NCFB

Year NCFL - NCFB Discount Factor PV (NCFL - NCFB)

0 $8,650,000 1.0000 $8,650,000
1 -$2,150,000 0.9434 -$2,028,302
2 -$2,630,000 0.8900 -$2,340,691
3 -$2,110,000 0.8396 -$1,771,597
4 -$1,830,000 0.7921 -$1,449,531
5 -$1,280,000 0.7473 -$956,490
NET ADVANTAGE TO LEASE $103,389

2. NAL = NPVL – NPVB

NPV of Leasing
Year CFt Dis.Factor PVCFt
0 -1,650,000 1.0000 -1,650,000
1 -1,650,000 0.9434 -1,556,604
2 -1,650,000 0.8900 -1,468,494
3 -1,650,000 0.8396 -1,385,372
4 -1,650,000 0.7921 -1,306,955
5 0 0.7473 0
NPVLease -7,367,424

NPV of Buying
Year CFt Dis.Factor PVCFt
0 -10,300,000 1.0000 -10,300,000
1 500,000 0.9434 471,698
2 980,000 0.8900 872,197
3 460,000 0.8396 386,225
4 180,000 0.7921 142,577
5 1,280,000 0.7473 956,490
NPVB -7,470,813

NAL ($7367424) - ($7470813) $103,389

As the net advantage to lease is positive, Anderson can accept the lease agreement.

IRR Analysis

IRR analysis for Anderson would require finding out the discount rate at which the NPV of
Incremental NCF will be zero. This involves trials with different discount rates and use of the
interpolation formula to locate IRR. The process is lengthy and you may not have to work on it
for exam purposes.
 LESSOR’S ANALYSIS

The lessor is the owner of the leased equipment. Therefore,

1. Lessor’s cash flows as the owner will be the same as the lessee’s under its buying analysis.
2. Lessor’s cash flows as the lessor will be the opposite of lessee’s cash flows under its lease
analysis i.e., lessee’s inflow shall be lessor’s outflow and lessee’s outflow shall be lessor’s
inflow.
a. Lessor will receive lease payments from the lessee. So for the lessee’s lease
payment will be lease payment receipt for the lessor and hence a cash inflow.
b. Lease payment by the lessee is income to the lessor. So payment tax savings for
the lessee will be tax payment for the lessor and hence cash outflow.

After calculating its net cash flow, the lessor will its own relevant opportunity cost to determine
NPV and IRR. The lessor will accept the lease agreement if the NPV is positive and the IRR is
higher than the opportunity cost of funding for the leased equipment.

Refer to the Anderson problem. Suppose that the investor can buy 5-year bonds that have a 9
percent yield to maturity providing an after tax yield of 9%(1 - 0.4) = 5.4%. This is the after-tax
return that the investor can obtain on alternative investment of similar risk, i.e. the opportunity
cost of capital.

The lessor’s calculation, analysis, and decision will be as follows.

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Lease investment
Net purchase price -$10,000,000
Maintenance cost -$500,000 -$500,000 -$500,000 -$500,000 -$500,000
Maintenance tax savings $200,000 $200,000 $200,000 $200,000 $200,000
Depreciation tax savings $800,000 $1,280,000 $760,000 $480,000 $480,000
Salvage value $1,000,000
Tax effect on sale -$200,000
Lease payments $2,750,000 $2,750,000 $2,750,000 $2,750,000 $2,750,000
Payment tax -$1,100,000 -$1,100,000 -$1,100,000 -$1,100,000 -$1,100,000
Net cash flow:NCF -$8,650,000 $2,150,000 $2,630,000 $2,110,000 $1,830,000 $1,280,000
Opportunity cost of capital 9%(1-0.4) 5.40%
Accept lease
NPV $24,797 Positive investment
Accept lease
IRR 5.52% >kDAT investment
While solving lease problems, be careful about two matters

1. Who pays for maintenance? If the lessee pays for maintenance, the cost and tax effect on it
(if any) has to be shown twice in the lessee’s analysis: once under lease cash flows and again
under buy cash flows.
2. Which payments are payable are payable at the beginning and which are payable at the end
of the year? Depreciation charges are always shown as end-of-year cash flows.

You are now equipped to tackle the textbook problems. Try solving problems 17-2, SS 17-1, SS
17-2, and SS 17-3. For the spreadsheet problems, only find out if the lease agreement should be
accepted or not. Be serious. This is not a break or vacation. You are supposed to stay indoors and
are expected to study.

I shall upload the solutions to the textbook problems on Sunday.

Best wishes,

Mahmudul Haq,

Instructor, FIN 427 (1 & 2)