Leasing ACC1 Addendum Corp FINC 5880 ANSWERS CLASS ASSIGNMENTS Shanghai – 2015

Class assignment Leasing: Assume the following case; A company considers and investment of $100; the asset is depreciated over 2 years straight line; no residual value and tax rate 40%; if the company borrow the money the interest is 10% per year A guideline lease requires a yearly lease fee of $55 Estimate the cash flows under the 2 scenarios; which has the lower present value? (assume dcf=6% this is the after tax cost of debt: 10%*(1-40%))

Answer: Buy and borrow…cash flows Cash flowsYear 0Year 1Year 2 Cost-$100 Loan+$100 Interest-$10 Tax saving+$4 Repay loan-$100 Tax saving depreciation +$20 Total$0+$14-$86

Answer: Lease cash flows Cash flowYear 0Year 1Year 2 Lease payment -$55 Tax saving lease payment $22 Total$0-$33

So calculate the PV (at 6%) Buy/Borrow PV(6%): $ Lease PV(6%): $60.50 The PV of the cost of Financing is lower under leasing…so…LEASE!

Class Assignment: Leasing Consider a $10 M investment (10 year life) to be discontinued after 5 year Borrow at 10% interest per year (before tax) if you Buy the Equipment After 5 years residual value $2 M A 5 year lease would trigger annual lease payments of $ 2,6M starting immediately in t=0 Under the lease the lessor maintains the equipment If the company buy/borrow this equipment the maintenance cost will need to be paid additionally at $0.5M per year at the beginning of each year starting immediately (t=0) Tax rate of the Lessee is 35% Modified Accelerated Cost Recovery System (MACRS) depreciation: over the 5 years is resp. 20%, 32%, 19%, 12% and 11% Compare the PV of the cost of owning (buy/borrow) with the PV of the cost of leasing….which one is lower?

Answer: cash flows (in $ 1000) if you Borrow and Buy… MUSDYr 0Yr 1Yr 2Yr 3Yr 4Yr 5 After tax loan payments ,650 Maintenance costs -500 Maintenance Tax savings 175 Depreciation Tax savings 7001, Residual Value 2,000 Tax on residual value -490 Total Cash Flow ,755

Answer: Leasing MUSDYr 0Yr 1Yr 2Yr 3Yr 4Yr 5 Lease payment -2,600 Payment Tax savings 910 Net Cash Flow -1,690

Comparing… In 1,000 USDBorrow & BuyLeasing Present Value at 6.5% (10% after tax 35%) - 7,534- 7,480 So: leasing is beneficial DisadvantageAdvantage (54)

Class assignment: From the Lessor’s point of view Assuming: Lessor’s tax rate is 40% Lessor’s alternative investment is a 5 year bond with an after tax yield of 9%(1-40%)=5.4% Asset will be depreciated to book value of $600,000 after 5 years and the before tax residual value is $ 2M This implies that Lessor can expect to receive $2M – 40%*$1.4M=$1,440,000 after the lease expires selling the asset directly… Develop the cash flows and determine the IRR% of this investment Is 5.4%>,< or= IRR%? So what would the lessor invest his money in in the Lease or the Bonds…?

Answer: Lessor’s cash flow (IRR%=5.8% > 5.4% on the Bond….) Yr 0Yr 1Yr 2Yr 3Yr 4Yr 5 purchase price asset -10,000 Maintenance from t= Maintenance tax savings 40% 200 Depreciation tax savings Lease payment 2,600 Tax on lease payment 40% -1,040 Residual value2,000 Tax on residual value ( )*40% -560 Cash flow-87402,0602,5402,0201,7401,880

IRR% calculation in Excel YEAR ,0602,5402,0201,7401,880 CASH FLOW5.75%IRR%