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    Finance involving depreciation and maximum before tax payment

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    1. Your firm wants to lease a $500,000 piece of equipment. The equipment has a 5-year life and a salvage value of $100,000 at the end of year 5. Depreciation is straight-line over 5 years to a zero book value. There will be 5 pre-paid lease payments on the equipment. Purchasing the asset has a positive NPV for your firm. Assume the tax rate is equal to your effective tax rate. The before-tax cost of debt is equal to the 5-year government bond rate plus the appropriate spread for your firm (based on the default risk).

    a) What is the maximum before-tax payment your firm is willing to make?
    b) Aside from changing the lease payment, what is one factor that will make leasing more attractive to your firm?

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    Solution Preview

    ** Please see the attached file for the complete solution response **

    a) This is a question of lease versus buy. The maximum lease payment would be such that the present value of lease
    is the same as the present value of buy.
    In buy, we have an outflow of $500,000 at the start and then depreciation tax shield for 5 years and the
    salvage value at the end of year 5. We find the PV of depreciation tax shield and the PV of salvage value
    and subtract from the initial investment. This gives the net cost of buy.
    In lease, we have 5 prepaid lease payments, we find the annuity amount which has the same ...

    Solution Summary

    In this solution, we show how to calculate the maximum before-tax payment that the given firm is willing to make, and how to determine one factor that will make leasing a more attractive option to purchasing. The solution is shown in Excel.

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