Kohers Inc is considering a leasing arrangement to finance some manufacturing tools that it needs for the next 3 years. The tools will be obsolete and worthless after 3 years. The firm will depreciate the cost of the tools on a straight-line basis over their 3 year life. It can borrow $4,800,000, the purchase price, at 10% and buy the tools, or it can make 3 equal end-of-year lease payments of $2,100,000 each and lease them. The loan obtained from the bank is a 3-year simple interest loan, with interest paid at the end of the year. The firm's tax rate is 40%. Annual maintenance costs associated with ownership are estimated at $240,000 but this cost would be borne by the lessor if it leases. What is the net advantage to leasing(NAL), in thousands?
(Suggestion:Delete 3 zeros from dollars and work in thousands)
Kohers Inc. is considering a leasing arrangement to finance some manufacturing tools that it needs for the next 3 years. The tools will be obsolete and worthless after 3 years. The firm will depreciate the cost of the tools on a straight-line basis over their 3-year life. It can borrow $4,800,000, the purchase price, at 10% and buy the tools, or it can make 3 equal end-of-year lease payments of $2,100,000 each and lease them. The loan obtained from the bank is a 3-year simple interest loan, with interest paid at the end of the year. The firm's tax rate is 40%. Annual maintenance costs associated with ownership are estimated at $240,000, but this cost would be borne by the lessor if it leases. What is the net advantage to leasing (NAL), in thousands? (Suggestion: Delete 3 zeros from dollars and work in thousands.)
To calculate the Net Advantage to Leasing (NAL), we need to compare the costs of leasing versus buying the tools over the 3-year period.
First, let's calculate the cost of buying the tools:
Loan amount = $4,800,000
Interest rate = 10%
Loan term = 3 years
The interest expense for the first year would be:
Interest expense = Loan amount * Interest rate = $4,800,000 * 0.10 = $480,000
The net after-tax interest expense for the first year (considering the 40% tax rate) would be:
Net interest expense = Interest expense * (1 - Tax rate) = $480,000 * (1 - 0.40) = $288,000
The net after-tax interest expense for the second year and third year would be the same.
Therefore, the total net after-tax interest expense over the 3-year period would be:
Total net interest expense = Net interest expense * 3 = $288,000 * 3 = $864,000
In addition to the interest expense, we also need to consider the annual maintenance costs associated with ownership, which are estimated at $240,000 per year.
Total maintenance costs over the 3-year period would be:
Total maintenance costs = Maintenance cost * 3 = $240,000 * 3 = $720,000
Now let's calculate the cost of leasing the tools:
Lease payments = $2,100,000 per year for 3 years = $2,100,000 * 3 = $6,300,000
Since the lessor would bear the maintenance costs, we do not need to consider these costs for leasing.
Now we can calculate the Net Advantage to Leasing (NAL) by comparing the total costs of buying versus leasing:
NAL = Total net interest expense + Total maintenance costs - Lease payments
= $864,000 + $720,000 - $6,300,000
= -$4,716,000 thousand
Therefore, the Net Advantage to Leasing(NAL) would be -$4,716,000 thousand.
To calculate the Net Advantage to Leasing (NAL), we need to compare the costs and benefits of buying the tools with a loan versus leasing the tools.
First, let's calculate the cost of buying the tools:
Loan amount = $4,800,000
Interest rate = 10%
Tax rate = 40%
Depreciation over 3 years = $4,800,000 / 3 = $1,600,000 per year (straight-line basis)
Year 1:
Loan payment = $4,800,000 * 0.10 = $480,000
Interest expense = $480,000 * (1 - 0.40) = $288,000 (after tax)
Depreciation expense = $1,600,000
Maintenance cost = $240,000
Total cost = Interest expense + Depreciation expense + Maintenance cost = $288,000 + $1,600,000 + $240,000 = $2,128,000
Year 2:
Loan payment = $0 (since the loan is for 3 years)
Interest expense = $0
Depreciation expense = $1,600,000
Maintenance cost = $240,000
Total cost = Depreciation expense + Maintenance cost = $1,600,000 + $240,000 = $1,840,000
Year 3:
Loan payment = $0
Interest expense = $0
Depreciation expense = $1,600,000
Maintenance cost = $240,000
Total cost = Depreciation expense + Maintenance cost = $1,600,000 + $240,000 = $1,840,000
Total cost of buying the tools over 3 years = $2,128,000 + $1,840,000 + $1,840,000 = $5,808,000
Now let's calculate the cost of leasing the tools:
Lease payment per year = $2,100,000
Tax rate = 40%
Maintenance cost = $0 (borne by the lessor)
Year 1:
Lease payment = $2,100,000
Tax shield on lease payment = $2,100,000 * 0.40 = $840,000
Total cost = Lease payment - Tax shield on lease payment = $2,100,000 - $840,000 = $1,260,000
Year 2:
Lease payment = $2,100,000
Tax shield on lease payment = $2,100,000 * 0.40 = $840,000
Total cost = Lease payment - Tax shield on lease payment = $2,100,000 - $840,000 = $1,260,000
Year 3:
Lease payment = $2,100,000
Tax shield on lease payment = $2,100,000 * 0.40 = $840,000
Total cost = Lease payment - Tax shield on lease payment = $2,100,000 - $840,000 = $1,260,000
Total cost of leasing the tools over 3 years = $1,260,000 + $1,260,000 + $1,260,000 = $3,780,000
Now we can calculate the Net Advantage to Leasing (NAL):
NAL = Cost of buying - Cost of leasing
NAL = $5,808,000 - $3,780,000 = $2,028,000
Since the NAL was calculated in thousands, we need to add the 3 zeros back to get the final answer:
Net Advantage to Leasing (NAL) = $2,028,000,000