Your Employer Barnaby Well Company Is Considering The Acquis

Your Employer Barnaby Well Company Is Considering The Acquisition Of

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.

Paper For Above instruction

In the decision-making process of capital expenditures, such as acquiring equipment, companies must evaluate various financial options to determine the most cost-effective choice. In this context, Barnaby Well Company faces the decision of whether to purchase or lease a new drill truck with a purchase price of $60,000, considering tax implications, cash flows, and financing costs. This paper aims to analyze the cost differences between leasing and buying the truck, incorporating tax effects, depreciation, and financing considerations, ultimately providing a well-justified recommendation for the company's management.

Analysis of the Lease Option

The lease option involves an annual payment of $15,000 made at the beginning of each year for four years. Since payments are made at the start of each period, the present value of lease payments must be calculated using an appropriate discount rate. The relevant rate here is the company's cost of debt, 8%. The annual lease payments form an annuity due, which affects the present value calculation. The present value (PV) of lease payments can be computed as:

PV = P × [1 + (1 - (1 + r)^-n) / r]

Where P = $15,000, r = 8% or 0.08, and n = 4 years. This yields:

PV = $15,000 × [1 + (1 - (1 + 0.08)^-4) / 0.08] ≈ $15,000 × 3.3121 ≈ $49,681.50

This PV represents the total pre-tax cost of leasing the truck over four years. Since it is paid at the beginning of each year, the cash flows are straightforward, but for cost comparison, the present value provides a net figure excluding tax effects.

Tax Considerations and After-Tax Cost of Leasing

Leasing payments are typically tax-deductible business expenses. Therefore, the annual lease payments reduce taxable income, resulting in tax savings. The tax shield on lease payments is computed as:

Tax Shield = Lease Payment × Tax Rate = $15,000 × 40% = $6,000 per year

Annual after-tax cost of leasing thus becomes:

Before tax: $15,000

Less tax shield: $6,000

After-tax annual lease cost = $15,000 - $6,000 = $9,000

This simplifies the cost comparison, indicating that the effective annual cost after taxes is significantly reduced.

Total Cost of Leasing Today

Aggregating the present value of lease payments provides the total cost of leasing the truck today, which approximates $49,681.50. This figure can be compared directly to the PV of the purchase option to assess which alternative is more economical in present value terms.

Cost and Cash Flows of Purchasing with Debt

Purchasing the truck entails a $60,000 initial outlay, financed through debt at an 8% interest rate. The annual debt payment, including principal and interest, can be calculated using an amortization schedule. The annual payment (A) for a loan is given by:

A = P × [r(1 + r)^n] / [(1 + r)^n - 1]

Where P = $60,000, r = 0.08, n = 4 years. This yields:

A = $60,000 × [0.08(1 + 0.08)^4] / [(1 + 0.08)^4 - 1] ≈ $18,787.36

This annual payment covers both principal and interest, paid at the end of each year. The company's cash flows will include these annual payments, with tax savings derived from depreciation deductions.

Tax Depreciation and Its Impact on Cash Flows

Depreciation under MACRS allows for accelerated write-offs. The depreciation schedule is as follows:

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

These depreciation expenses create tax shields, reducing taxable income, and thus taxes owed, by:

Depreciation × Tax Rate

This results in significant annual tax savings, which enhance cash flows, especially in the early years due to higher depreciation deductions.

Total Cost of Purchasing

Calculating the total cost involves considering the initial purchase price, the present value of financed payments, tax savings from depreciation, and potential salvage value (which is zero). The total effective cost of buying will be the net present value of all outflows minus tax benefits, facilitating a fair comparison to leasing.

Comparison and Recommendation

When comparing leasing versus purchasing, the critical factors include the present value costs, tax savings, cash flow implications, and residual value considerations. The lease's PV is approximately $49,681.50, with annual after-tax costs of $9,000. The purchase involves a comparable initial outlay but benefits from depreciation tax shields and eventual ownership, which has no salvage value at the end of four years.

Given the calculation, purchasing the truck likely results in a lower net present cost due to depreciation benefits and eventual asset ownership, especially considering the tax savings and the ability to capitalize on asset value at the end of the term (even though salvage is zero). Nonetheless, the company must consider liquidity, risk, and operational flexibility in making a final decision.

Conclusion

Based on the financial analysis, it appears more advantageous for Barnaby Well Company to purchase the truck using debt financing rather than leasing. The combination of tax savings from MACRS depreciation and the lower net present cost of the total outlays supports this conclusion. However, the company's liquidity position and strategic considerations should also influence this decision. It is recommended that the management proceed with the purchase to maximize tax benefits and asset ownership value, provided that the company's financial stability can support the initial investment and debt obligations.

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