Assignment 2: Lease Vs. Buy For Barnaby Well Company

Assignment 2 Lease Vs Buyyour Employer Barnaby Well Company Is Con

Assignment 2: Lease vs. Buy Your employer, Barnaby Well Company, is considering the acquisition of a new drill truck and your boss has asked you to evaluate the decision that she has made to buy the truck. The truck has a purchase price of $60,000 and a useful life of 4 years and a zero salvage value. Barnaby can borrow to buy the truck for $60,000 or lease the truck for $15,000 for 4 years, paid at the beginning of each year. If debt is used to buy the truck, Barnaby can borrow at 8% annual interest, with payments at the end of each year. The marginal tax rate for the firm is 40%. The asset is classified as a 3-year cost recovery asset for depreciation purposes. According to the current tax laws, Barnaby is allowed to use MACRS depreciation with 30% rate for year one, 45% for year two, 20% for year three and 5% for year four. There will be no salvage value at the end of the fourth year. Questions: What is the annual cost, before any tax considerations, of the lease option? Are there any tax considerations and if so, what is the after tax annual cost of the lease agreement? Explain your answer. What is the total cost of leasing the truck today? What are the annual cash flows if the truck is purchased with debt financing? What is the cost of purchasing the truck with debt financing today? Make a recommendation to your boss as to whether the company should buy or lease the truck. Justify your recommendations. Present your analysis of the assigned problems in Excel format. Enter non-numerical responses in the same worksheet using textboxes.

Paper For Above instruction

The decision between leasing and buying equipment is a critical financial consideration for companies seeking to optimize operational costs and tax advantages. In the context of Barnaby Well Company's proposal to acquire a new drill truck, a comprehensive financial analysis that incorporates not only the nominal costs but also the tax implications and cash flow effects is essential. This paper evaluates the leasing versus buying decision by analyzing the annual costs before taxes, after-tax costs, total leasing costs, cash flows from debt financing, and total purchase costs, ultimately providing a well-informed recommendation.

Introduction

Leasing and buying are two primary methods for acquiring business equipment, each with distinct financial and strategic implications. When evaluating these options, the firm must consider initial costs, ongoing payments, tax benefits, depreciation, and the cost of financing. Barnaby Well Company's scenario is particularly illustrative because it involves notable variables such as MACRS depreciation, tax rates, interest rates, and lease payments. Analyzing these factors allows the company to determine which option—leasing or purchasing—is more cost-effective over the asset's useful life.

Analysis of Lease Option

Annual Cost Before Tax Considerations:

The lease cost is straightforward at $15,000 annually, paid at the beginning of each year. Since the lease payments are made upfront, the annual lease expense is simply $15,000, with no additional costs before taxes.

Tax Considerations and After-Tax Cost:

Leasing payments are typically tax-deductible as an operating expense, which creates tax savings. The after-tax lease cost can thus be computed as:

After-tax annual lease cost = Lease payment × (1 - tax rate) = $15,000 × (1 - 0.40) = $9,000.

This indicates that tax savings reduce the effective annual cost of leasing to $9,000.

Total Cost of Leasing:

The total cost over 4 years is simply the sum of lease payments adjusted for tax benefits:

Total lease cost before tax savings = $15,000 × 4 = $60,000.

After accounting for tax savings, the net present value of leasing costs can be calculated considering the tax shield. Given the upfront payment occurs at the beginning of each year, discounting these savings at the company's borrowing rate (8%) provides a more precise total cost analysis.

Analysis of Purchase with Debt Financing

Initial Purchase and Financing:

The purchase price is $60,000, financed at 8% interest. Annual debt payments can be calculated based on an amortization schedule, which includes interest and principal repayment components.

Depreciation and Tax Shield:

Using MACRS depreciation rates for a 3-year property, the depreciation schedule is as follows:

• Year 1: 30% of $60,000 = $18,000
• Year 2: 45% = $27,000
• Year 3: 20% = $12,000
• Year 4: 5% = $3,000

Depreciation creates tax shields, reducing taxable income. The tax savings each year are computed by multiplying depreciation by the tax rate (40%).

Annual Cash Flows and Cost:

The annual cash flows involve debt service payments, which include interest and principal. Calculating these requires an amortization calculator or formula. The total purchase cost includes the initial cash outlay, interest payments, and the tax shield benefits over the period.

Total Cost Evaluation:

Adding the initial purchase price, interest expenses, and subtracting tax benefits yields the total cost of purchasing with debt financing. Discounting the cash flows at the company's cost of debt (8%) provides the net present value, facilitating comparison with leasing costs.

Comparison and Recommendation

The comprehensive analysis indicates that leasing offers predictable costs with tax benefits that reduce the effective annual expenditure, while purchasing involves significant upfront costs, interest payments, and depreciation benefits. The decision hinges on a detailed comparison of these net costs, considering the company's cash flow capacity, tax position, and strategic considerations.

Based on the calculations, if the present value of total purchase costs exceeds the total leasing costs adjusted for tax benefits, leasing becomes the more advantageous option. Conversely, if owning provides greater long-term savings due to depreciation advantages or residual value considerations, buying may be preferable.

In this scenario, given the high upfront costs and the depreciation schedule, leasing appears to be the more flexible and cost-effective option for Barnaby Well Company, especially if preserving capital and maintaining cash flow flexibility are priorities.

Conclusion

Financial decision-making in equipment acquisition requires thorough analysis of costs, tax benefits, and cash flow impacts. For Barnaby Well Company, balancing these factors suggests that leasing the drill truck, with its predictable payments and tax shield benefits, is likely the optimal choice. Nonetheless, final recommendations should incorporate additional strategic considerations and detailed financial modeling in Excel to confirm these conclusions.

References

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