Chapter 8 Problem 2 Big Sky Hospital Answer

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Chapter 8 Problem 2
Big Sky Hospital plans to obtain a new MRI that costs $1.5 million and has an estimated four-year useful life. It can obtain a bank loan for the entire amount and buy the MRI, or it can obtain a guideline lease for the equipment. Assume that the following facts apply to the decision:

– The MRI falls into the three-year class for tax depreciation, so the MACRS allowances are 0.33, 0.45, 0.15, and 0.07 in Years 1 through 4, respectively.
– Estimated maintenance expenses are $75,000 payable at the beginning of each year whether the MRI is leased or purchased.
– Big Sky’s marginal tax rate is 40 percent.
– The bank loan would have an interest rate of 15 percent.
– If leased, the lease payments would be $400,000 payable at the end of each of the next four years.
– The estimated residual (and salvage) value is $250,000.

a. What are the NAL and IRR of the lease? Interpret each value.
b. Assume now that the salvage value estimate is $300,000, but all other facts remain the same. What is the new NAL? The new IRR?

(Hint: Use the following format as a guide.)

Year 0 Year 1 Year 2 Year 3 Year 4
Cost of owning:
Net purchase price
Maintenance cost
Maintenance tax savings
Depreciation tax savings
Residual value
Tax on residual value
Net cash flow

Cost of leasing:
Lease payment
Lease tax savings
Maintenance cost
Maintenance tax savings
Net cash flow

Net advantage to leasing:
PV cost of leasing
PV cost of owning