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St. Martin's Hospital plans to purchase or lease a $2 million CT scanner. If purchased, the CT scanner will be depreciated on a straight-line basis over five years, after which it will be worthless. If leased, the annual lease payments will be $500,000 per year for five years. St. Martin's borrowing cost is 8%, and its tax rate is 35%.
-What is the amount of the lease-equivalent loan for the CT Scanner?
A) $74,890.28
B) $1,749,890.28
C) $3,487,027.19
D) $2,367,559.51

Question

Quizplus · Accepted Answer

B) First we construct the FCF from leasing and buying. The FCF from leasing are the annual lease payments × (1 − τ_c) since these payments are deductible for tax purposes. The FCF from buying represents the original cost of the purchase in year 0 and the depreciation tax shield of ($2 million / 5 years) × .35. The free cash flows are as follows: 11ea84dc_f4a6_e0c1_9a63_3d4638f3885c_TB1316_00_TB1316_00 The amount of the lease equivalent loan is equal to the present value of the difference in FCFs from years 1 to 5 discounted at the after tax borrowing rate (.08)(1 - .35) = .052 or 5.2%. LEL = 11ea84dc_f4a6_e0c2_9a63_75345da5d06e_TB1316_11_TB1316_11 + 11ea84dc_f4a7_07d3_9a63_176d51dde42a_TB1316_11_TB1316_11 + 11ea84dc_f4a7_07d4_9a63_37a2886959fe_TB1316_11_TB1316_11 + 11ea84dc_f4a7_07d5_9a63_63a28407e701_TB1316_11_TB1316_11 + 11ea84dc_f4a7_2ee6_9a63_3f6221ea6ac7_TB1316_11_TB1316_11 = $1,749,890

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