Lease and Term Loan Analysis
Suppose that Kinko's Copy Centers has decided to install personal computers and printers in its Pittsburgh store that will be rented to customers on an hourly basis. Kinko's management has called in consultants from a number of computer suppliers to assist it in designing a system. After considering a number of alternatives, Kinko's decided that an Apple Computer system consisting of eight Macintosh computers and two printers best meets its current and projected future needs. Kinko's evaluated the desirability of the acquisition of the Apple computer system using its normal capital budgeting procedures.
It found that the computer system has a large positive expected net present value. Jim Horn, a new management trainee in the financial planning office, has recently been reading about the boom in the leasing industry. He feels that if leasing is growing as rapidly as it seems, there must be some significant advantages to the leasing alternative compared to ownership. If purchased, the new computer system will cost $50,000 installed. The computer system has an estimated economic life of six years. Kinko's would depreciate the computer system as a 5-year class asset under MACRS rules to a $0 estimated salvage value.
If purchased, Kinko's could borrow the needed funds from PNC Bank at a 10 percent pretax annual percentage rate of interest. If Kinko's decides to lease the computer system, it will be required to make six beginningof-year lease payments of $11,000 each. Kinko's weighted cost of capital is 12 percent (aftertax). Kinko's marginal tax rate is 40 percent. Under both the lease alternative and the borrow-and-buy alternative, Kinko's will contract with a computer service company to handle the estimated annual service and maintenance costs.
1. Compute the net advantage to leasing.
2. Which alternative should Kinko's accept? What other factors might be considered?
3. If the computer system is owned and Kinko's borrows the needed funds from PNC in the form of a bullet loan carrying a 10 percent interest rate instead of an equal payment loan at 10 percent, what effect would this have on the decision to lease or buy?
4. What effect would the use of straight-line depreciation have on the lease-buy decision? (Answer verbally; no calculations are needed. Ignore the bullet loan assumption in question 3.)
5. If, at the end of six years, the computer system is expected to have an actual salvage value of $5,000, what would be the impact on the net advantage of leasing?