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Net Advantage to Leasing; Reverse Splt

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A.The financial manager of Time Press Inc. is considering installing a printing machine for \$400,000. The machine will be depreciated using straight line method with zero residual value over a period of 4 years. Alternatively, the firm can lease the printing machine with an annual lease payment of \$132,000 over 4 years. The corporate tax rate is 40%. Assume the firm can borrow at 10% before taxes.

ii) Determine the maximum annual lease payment that the firm will pay to rent the printing machine.
iii) During the board meeting, the CFO made the following statement: "If the tax advantages of leasing were eliminated, leasing would disappear. " How would you respond? Explain.

b. Explain whether you agree with the following claim from the chief executive officer during the board meeting: 'It is a good suggestion to have a reverse split if we wish to raise the share price of the firm.

Solution Preview

See the attached file.
I have responded to parts i. and ii. of problem a) in the attached Excel 97-2003 worksheet. As you can see by it, we determine the net advantage to leasing by discounting the net after-tax cash flows of owning (which is really just the tax benefit of the depreciation) and deduct the initial cash outlay. We then discount the after-tax cash flows from leasing. The excess of the net cost of owning over the net cost of leasing is the net advantage to leasing. Likewise, we will choose owning over leasing when the net advantage to leasing disappears (i.e., the net cost of leasing equals the net cost of owning.)

In response to part iii. of problem a), I disagree with the CFO ...

Solution Summary

Using an Excel 97-2003 spreadsheet, this solution illustrates how to compute the net advantage to leasing an asset. It then discusses the pros and cons of performing a reverse split.

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