Lessee Analysis

Question 1

The conventional format of analyzing lease-versus-purchase decision assumes that the money to buy the equipment will be obtained by borrowing. However, Environmental Sciences Inc. has enough internally generated capital which is held in the form of marketable securities, to buy the equipment outright. If the company purchases the equipment with the capital on hand instead of purchasing it via borrowing, it will lose the advantages of tax savings generated by borrowing money since the interest payments are tax deductible. Moreover, when it spends $1,375,000 at one time, it may miss the opportunity of investing the money on the projects estimated to have high net present values. This kind of investment opportunities may not be available in the future. Therefore, these considerations should be taken into account during the lease-versus-purchase analysis.Net Present Value - NPV is the difference between the present value of cash inflows and the present value of cash outflows. If NPV is greater than 0, the project should be accepted because its cash flows are positive and the company gains from this project. If NPV is lower than 0, the project should be rejected. NPV tells whether the investment will increase the firm's value, it considers all the cash flows, the time value of money and the risk of future cash flows.

At the end of fourth year, company's residual value is equal to ending book value that is 233.750 and also company uses 11% after-tax discount rate and residual value discount rate. NPV calculation is done differently because of having residual value at the end of fourth year and is calculated as:

Initial cost + NPV + (Depreciation Shield + Lease Payment + Lease Pmt Tax) / [(1+ Opp. Cost)*(1-Tax)]4 + (Residual + RV Tax) / (1+ (RV Discount Rate*(1- Tax)))4

Given the knowledge that, Environmental Sciences Inc. has to carry residual value and lease payments back addition to cash flows.

According to this calculation:

Lessor's NPV = 18.715,66

Lessor's IRR = 12%

The NPV of the lease will be $18,716 which indicates that the PV cost of owing is greater and this makes the current deal profitable for them. Therefore, borrowing and buying are more expensive than leasing, so Environmental Sciences Inc. should lease the equipment rather than purchase.

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