Chapter 5: Q1P-a (page 542)

Howell Auto Parts is considering whether to borrow funds and purchase an asset or to lease the asset under an operating lease arrangement. If the company purchases the asset, the cost will be $10,000. It can borrow funds for four years at 12 percent interest. The firm will use the three-year MACRS depreciation category (with the associated four-year write-off). Assume a tax rate of 35 percent.
The other alternative is to sign two operating leases, one with payments of $2,600 for the first two years, and the other with payments of $4,600 for the last two years. In your analysis, round all values to the nearest dollar.
a. Compute the after-tax cost of the leases for the four years.

Expert verified

The after-tax cost of leases will be $1,690 in the first two years and $2,990 in the last two years.

Step by step solution

Tax rate = 35%

Payment for first two years = $2,600

Payment for las two years = $4,600

The after-tax cost of leases will be $1,690 in the first two years and $2,990 in the last two years.

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Liabilities and stockholder’s claims
Liabilities
Accounts payable	\(2,800,000
First lien, secured by machinery and equipment	\)900,000
Senior unsecured debt	\(2,200,000
Subordinated debenture	\)1,700,000
Total liabilities	\(7,600,000
Stockholder’s claims
Preferred stock	\)250,000
Common stock	\(650,000
Total stockholder’s claims	\)900,000
Total liabilities and stockholder’s claims	$8,500,000

Bailey corporation
Income statement
For the year 20X1
Sales (all on credit)	\(42,680,000
Cost of goods sold	\)32,240,000
Gross profit	\(10,440,000
Selling and administrative expenses	\)4,558,000
Operating profit	\(5,882,000
Interest expense	\)600,000
Net income before taxes	\(5,282,000
Taxes	\)2,120,000
Net income	\(3,162,000

Bailey corporation
Balance sheet
As of December 31, 20X1
Assets
Current assets:
Cash	\)250,000
Marketable securities	\(130,000
Accounts receivables	\)6,000,000
Inventory	\(8,300,000
Total current assets	\)14,680,000
Net plant and equipment	\(13,970,000
Total assets	\)28,650,000
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable	\(3,800,000
Notes payable	\)3,550,000
Total current liabilities	\(7,350,000
Long-term liabilities	\)5,620,000
Total liabilities	\(12,970,000
Stockholder’s equity:
Common stock (1,800,000 shares at \)1 par)	\(1,800,000
Capital in excess of par	\)6,300,000
Retained earnings	\(7,580,000
Total stockholder’s equity	\)15,680,000
Total liabilities and stockholder’s equity	$28,650,000