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Q-leasing

Procter and Gamble (P&G) is evaluating whether to purchase or lease manufacturing equipment costing $19 million, with NPV calculations indicating that leasing (-$10.57 million) is more financially attractive than financing the purchase (-$16.94 million). The break-even lease rate for P&G, where it would be indifferent between leasing and financing, is calculated to be approximately $6.88 million per year. Additionally, Amazon is considering leasing $48 million in equipment, with the lessor needing to determine a lease rate that allows for break-even, while Amazon benefits from the tax advantages associated with leasing due to its lower tax rate compared to the lessor's higher rate.

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4 views

Q-leasing

Procter and Gamble (P&G) is evaluating whether to purchase or lease manufacturing equipment costing $19 million, with NPV calculations indicating that leasing (-$10.57 million) is more financially attractive than financing the purchase (-$16.94 million). The break-even lease rate for P&G, where it would be indifferent between leasing and financing, is calculated to be approximately $6.88 million per year. Additionally, Amazon is considering leasing $48 million in equipment, with the lessor needing to determine a lease rate that allows for break-even, while Amazon benefits from the tax advantages associated with leasing due to its lower tax rate compared to the lessor's higher rate.

Uploaded by

Vaibhav Lathad
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Q.

Suppose Procter and Gamble (P&G) is considering purchasing $19 million in new manufac-
turing equipment. If it purchases the equipment, it will depreciate it on a straight-line basis
over the five years, after which the equipment will be worthless. It will also be responsible
for maintenance expenses of $2 million per year. Alternatively, it can lease the equipment for
$4.3 million per year for the five years, in which case the lessor will provide necessary mainte-
nance. Assume P&G’s tax rate is 40% and its borrowing cost is 7.5%.
a. What is the NPV associated with leasing the equipment versus financing it with the lease-
equivalent loan?
b. What is the break-even lease rate—that is, what lease amount could P&G pay each year and
be indifferent between leasing and financing a purchase?

Answer –

a. NPV of Leasing vs. Financing

To compare leasing and financing, we need to calculate the net present value (NPV) of each option.

Financing the Purchase


 Initial Investment: $19 million
Annual Depreciation: =$19million / 5years=$3.80

Annual Maintenance: $1.25 million

Tax Savings (Depreciation): =$3.8million×40%=$1.52

Tax Savings (Maintenance): =$1.25million×40%=$0.50

After−Tax Cash Outflows: =$1.25million−$0.5million=$0.75

We'll discount these cash outflows at P&G's borrowing cost of 7.0%.


Discount Factor
Year After-Tax Cash Outflow Present Value
(7%)
0 $19.00 million 1 $19.00 million
1 $0.75 million 0.9346 $0.70 million
2 $0.75 million 0.8734 $0.65 million
3 $0.75 million 0.8163 $0.61 million
4 $0.75 million 0.7629 $0.57 million
5 $0.75 million 0.713 $0.53 million

NPV of Financing: =−$19.00million+$0.70million+$0.65million+$0.61million+$0.57million+$0.53million=$


−15.94

Option 2: Leasing
 Annual Lease Payment: $4.3 million
Tax Savings (Lease Payment):=$4.3million×40%=$1.72

After−Tax Cash Outflows: =$4.3million−$1.72million=$2.58


We'll discount these cash outflows at P&G's borrowing cost of 7.0%.
After-Tax Cash Discount Factor
Year Present Value
Outflow (7%)
1 $2.58 million 0.9346 $2.41 million
2 $2.58 million 0.8734 $2.25 million
3 $2.58 million 0.8163 $2.10 million
4 $2.58 million 0.7629 $1.97 million
5 $2.58 million 0.713 $1.84 million

NPV of Leasing: −=−$2.41million−$2.25million−$2.10million−$1.97million−$1.84million=$−10.57


Comparison:
The NPV of leasing (-$10.57 million) is higher than the NPV of financing (-$16.94 million). This means
that leasing is the more financially attractive option for P&G.

b. Break-Even Lease Rate

To find the break-even lease rate, we need to find the annual lease payment that would make the NPV of
leasing equal to the NPV of financing.

Let 'X' be the break-even after-tax lease payment.

We can use the following equation:

NPV of Financing −X × [11+0.07+1(1+0.07)2+1(1+0.07)3+1(1+0.07)4+1(1+0.07)5]

Solving for X:

X=16.94million / 4.1002=4.1315

Explanation:
Since the tax savings is 40%, the break-even pre-tax lease payment would be:

A=$4.13million / 1−0.40=$6.88

Q. Suppose Amazon is considering the purchase of computer servers and network infrastructure
to expand its very successful business offering cloud-based computing. In total, it will purchase
$48 million in new equipment. This equipment will qualify for accelerated depreciation: 20%
can be expensed immediately, followed by 32%, 19.2%, 11.52%, 11.52%, and 5.76% over the
next five years. However, because of the firm’s substantial loss carryforwards and other credits,
Amazon estimates its marginal tax rate to be 10% over the next five years, so it will get very little
tax benefit from the depreciation expenses. Thus, Amazon considers leasing the equipment
instead. Suppose Amazon and the lessor face the same 8% borrowing rate, but the lessor has
a 35% tax rate. For the purpose of this question, assume the equipment is worthless after five
years, the lease term is five years, and the lease qualifies as a true tax lease.
a. What is the lease rate for which the lessor will break even?
b. What is the gain to Amazon with this lease rate?
c. What is the source of the gain in this transaction?

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