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Lease Vs. Buy, Financing and Capital Structure

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1) Lease or Buy. Your company wants to purchase a new network file server for its wide-area computer network. The server costs \$75,000. It will be completely obsolete in three years. Your options are to borrow the money at 10 percent or to lease the machine. If you lease, the payments will be \$27,000 per year, payable at the end of each of the next three years. If you buy the server, you can depreciate it straight-line to zero over three years. The tax is 34 percent. Should you lease or buy?

2) Financing and Capital Structure: Construct a project analysis under conditions of uncertainty; construct a lease vs buy analysis. Prepare an EBIT/EPS analysis.

3) Examine how firms raise capital and the roles of intermediaries.

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1. Lease or Buy. Your company wants to purchase a new network file server for its wide-area computer network. The server costs 75,000. It will be completely obsolete in three years. Your options are to borrow the money at 10 percent or to lease the machine. If you lease, the payments will be 27,000 per year, payable at the end of each of the next three years. If you buy the server, you can depreciate it straight-line to zero over three years. The tax is 34 percent. Should you lease or buy?

Cost of server \$75,000

Tax rate 34%

interest rate 10%

Year 0 Year 1 Year 2 Year 3

Depreciation \$25,000 \$25,000 \$25,000 =75000/3

(straight line depreciation)

Tax shield on depreciation @ 34% \$8,500 \$8,500 \$8,500 =0.34*25000

Lease payments \$27,000 \$27,000 \$27,000

Tax shield on lease payments @ 34% \$9,180 \$9,180 \$9,180 =0.34*27000

Cash flow consequences of lease contract

Year 0 Year 1 Year 2 Year 3

Cost of server \$75,000

The company does not have to pay for the server

This is equivalent to a cash flow of \$75,000

Lost depreciation tax shield -\$8,500 -\$8,500 -\$8,500

Lease payment -\$27,000 -\$27,000 -\$27,000

Tax shield on lease payments \$9,180 \$9,180 \$9,180

\$75,000 -\$26,320 -\$26,320 -\$26,320

Interest rate= 10%

After tax interst rate=r(1-T)= 6.60% =10%*(1-34%)

If we discount the cash flow at after tax interest rate= 6.60%

Year Cash flow Discount factor =1/(1+r)^t Cash flow X Discount factor

0 \$75,000 1 \$75,000

1 -\$26,320 0.938086304 -\$24,690

2 -\$26,320 0.880005914 -\$23,162

3 -\$26,320 0.825521495 -\$21,728

NPV=&#931;= \$5,420

Thus the lease option has a positive NPV= \$5,420

Hence the company should lease

Financing and Capital Structure: Construct a project analysis under conditions of uncertainty; construct a lease vs buy analysis. Prepare an EBIT/EPS analysis.

Project analysis under conditions of uncertainty:

Source (www.enrichconsulting.com/articles/09092002HBS.pdf)

The traditional NPV (Net Present Value ) criteria assumes conditions of low uncertainty: The market conditions are known, the costs to completion of the project are predictable, the technologies involved are reliable, and the odds of winning any necessary regulatory approval are favorable. ...