Lease vs Buy analysis
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(Net advantage to leasing) Lake Trolley Company is considering whether to lease or buy a new trolley that costs $25,000. The trolley can be depreciated straight line over an eight-year period to an estimated residual value of $5,000. Lake Trolley's cost of eight-year secured debt is 12%. Its required return for the project is 16% after tax and 20% pretax. National Trolley Leasing Corporation has offered to lease the trolley to Lake Trolley in return for annual payments of $5,000 payable at the end of each year.
a. Specify the incremental cash flow stream associated with the lease, assuming Lake Trolley's marginal income tax rate is 40%.
b. Calculate the net advantage to leasing, assuming Lake Trolley's tax rate is 40%. Should Lake Trolley lease, or borrow and buy?
c. Calculate the net advantage to leasing, assuming Lake Trolley's tax rate is zero. Should Lake Trolley lease, or borrow and buy?
d. How would your answers to parts b and c change if the residual value at the end of eight years is $500, but the trolley is depreciated to $5,000?
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