Republic of the Philippines

SURIGAO DEL SUR STATE UNIVERSITY

Tandag City, Surigao del Sur

GRADUATE SCHOOL

Glen Christian M. Teňozo

MBA – 1
BA 209 – Financial Management

Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles

The Olsen Company has decided to acquire a new truck. One alternative is to
lease the truck on a 4-year contract for a lease payment of Php500,000 per year, with
payment to be made at the beginning of each year. The lease would include
maintenance. Alternatively, Olsen could purchase the truck outright for Php2,000,000,
financing with a bank loan for the net purchase price, amortized over a 4-year period at
an interest rate of 10% per year, payments to be made at the end of each year. Under
the borrow-to-purchase arrangement, Olsen would have to maintain the truck at a cost
of Php50,000 per year, payable at year-end. The truck falls into the MACRS 3-year
class. The applicable MACRS depreciation rates are 33%, value after 4 years, at which
time Olsen plans to replace the truck regardless of whether the firm leases the truck or
purchases it. Olsen has a state tax rate of 40%.

1. What is Olsen’s PV cost of leasing?

BEGINNING OF THE LEASE

YEAR 0 1 2 3

Lease Payment, net of tax *P300,000 P300,000 P300,000 P300,000

Present Value of Cost of Leasing (P300,000x 3.4651) P1,039,530

 In lease or purchase decision, all cash inflows and outflows should be discounted
including all tax benefits derived from each alternative.
 After tax payment = P500,000 x (1 - .40) = P300,000.
 In computing the Present Value (PV) of the future payments, we will use the
after-tax interest rate [10% x (1 - .40)] = 6% with 4 years term.
 PV of OA 1 computations for 4 periods:
= [(1.06)^-4)] – 1
0.06
= 3.4651
 The Present Value of Ordinary Annuity of 1 is 3.4651
 Republic of the Philippines
SURIGAO DEL SUR STATE UNIVERSITY
Tandag City, Surigao del Sur

GRADUATE SCHOOL

2. What is Olsen’s PV cost of owning? Should the truck be leased or purchased?

Cashflows under borrow or buy alternative:

YEAR 0 1 2 3 4

Depreciation schedule
Depreciable basis P2M P2M P2M P2M
Multiply by
Depreciation rate 0.33 0.33 0.33 0.33
Depreciation P660,000 P660,000 P660,000 P660,000

Cash flows

Net Purchase Price P2M

Depreciation tax savings P240,000 P240,000 P240,000 P240,000
Maintenance, net of tax (P30,000) (P30,000) (P30,000) (P30,000)
Total Cash flows (P2M) P210,000 P210,000 P210,000 P210,000

Present Value of Cost of Buying (P210,000x 3.4651) P727,671

PV Cost of Leasing P1,039,530

PV Cost of Buying P727,671
Savings P311,859

The present value cost of buying is lower than the present value cost of leasing, Olsen
Company should buy the new truck because the entity can have a net savings up to
P311,859 for the 4 – year life of the truck.

 Maintenance expenses, net of tax = P50,000 x (1 – 0.40) = P30,00

 PV of OA 1 computations for 4 periods:
= [(1.06)^-4)] – 1
0.06
= 3.4651
 The Present Value of Ordinary Annuity of 1 is 3.4651
 Republic of the Philippines
SURIGAO DEL SUR STATE UNIVERSITY
Tandag City, Surigao del Sur

GRADUATE SCHOOL

3. The appropriate discount rate for use in Olsen’s analysis in the firm’s after-tax cost of
debt. Why?

The discount rate is based on the cost of debt because more cash flows are fixed
by contract and consequently, are relatively certain. Thus, the lease cash flows have
about the same risk as the firm’s debt. Also, leasing is considered to be a substitute for
debt. We will use an after-tax cost rate because cash flows are stated net of taxes.

4. The salvage value is the least certain cash flow in the analysis. How might Olsen
incorporate the higher risk of this cash flow into the analysis?

The salvage value is the least certain cash flows flow in the analysis because this
amount may fluctuate after being used over its useful life. The entity cannot assure that
they can sell the asset at exactly the same amount as its salvage value. Example, the
entity purchased a machinery worth P500,000 with P50,000 salvage value over 5 useful
lives. After the 5th year, the entity can either sell its depreciated asset to outside buyer
at P50,000 or lower depending on the asset’s physical structure and usefulness.

The firm could increase the discount rate on the salvage value cash flows. This
could increase the present value cost of buying (owning) or leasing more
advantageous.