Firm X needs 1 computer. There are two options available: Firm X can buy 1 computer for 2,000; or Firm X can enter into a true-tax lease for 2 years with 600 yearly payment, the first due immediately (3 payments: at 0,1, and 2). The cost of debt for Firm X is 5%. The corporate tax equals 35%. Firm X follows a straight-line depreciation method and the economic life of the computer is 2 years. Compute which method (buying or leasing) is the best to obtain the computer.Which alternative is best:Answer choices:A) LeasingB) Buying with a loanC) Leasing or buying are equivalent.

Question
Asked Nov 13, 2019
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Firm X needs 1 computer. There are two options available: Firm X can buy 1 computer for 2,000; or Firm X can enter into a true-tax lease for 2 years with 600 yearly payment, the first due immediately (3 payments: at 0,1, and 2). The cost of debt for Firm X is 5%. The corporate tax equals 35%. Firm X follows a straight-line depreciation method and the economic life of the computer is 2 years. Compute which method (buying or leasing) is the best to obtain the computer.

Which alternative is best:

Answer choices:
A) Leasing
B) Buying with a loan
C) Leasing or buying are equivalent.
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Expert Answer

Step 1

Computation of cost of leasing:

Post-tax cost of debt = Cost of debt x (1 - tax
= 5%x (1-0.35)
= 3.25%
Cost of leasing = Lease payment x(1- tax)x PV of annuity@3.25% for 2 years
600 x (1-0.35) x1.9065
743.535
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Post-tax cost of debt = Cost of debt x (1 - tax = 5%x (1-0.35) = 3.25% Cost of leasing = Lease payment x(1- tax)x PV of annuity@3.25% for 2 years 600 x (1-0.35) x1.9065 743.535

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Step 2

Computation of cost of buying:

G23
G
A
D
F
Depreciation Interest@5%
1000
1000
Total expense Tax savings@35%
100
100
2 Year
1100
1100
385
385
1
2
4
6
Interest
Tax savings@35%Cashflows
100
10
2000
PV@ 3.25%
0.9685
80
0.9380
Cost of buying
PV of cashflows
-276.02
7Year
1
-385
285
8
-385
285
-267.33
2
2000
1876.00
10
1332.65
11
12
13
CO
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G23 G A D F Depreciation Interest@5% 1000 1000 Total expense Tax savings@35% 100 100 2 Year 1100 1100 385 385 1 2 4 6 Interest Tax savings@35%Cashflows 100 10 2000 PV@ 3.25% 0.9685 80 0.9380 Cost of buying PV of cashflows -276.02 7Year 1 -385 285 8 -385 285 -267.33 2 2000 1876.00 10 1332.65 11 12 13 CO

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Step 3

Hence, the Firm X should go for leasing because its cost is lower than cost of buying.

Answer: (A)...

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