Lease Financing & Evaluate Cost of Capital Harvard Case Solution & Analysis

Health Plan northwest

Introduction

The Health-Plan Northwest is a company that operates in the field of hospital. They run their business by providing services to the patients and earn their revenue from them. Now the company is considering purchasing the computer which has the cost of 1.5million. The problem now being faced by the company was whether to lease the asset or purchase the asset. There are two methods to finance this transaction, either they could purchase from their equity or they could go for the lease option. Now the analysis has been performed on both aspects, which shows that purchasing from their equity is less cost effective than leasing the equipment. The analysis has been performed on the basis of some assumptions which have been given in the case, in which the bank charges the interest at the cost of 10%. The marginal tax rate was 34%and the purchase proposal had been evaluated on the basis of the MACRS depreciation method which incorporates the benefit of tax allowance. The lease payment has been given in the case which was $480,000 and the salvage value of the asset was $ 200,000. Now the following question has been discussed in the detailed analysis.

Questions

  • What are the NAL and IRR of the lease? Interpret each value

Answer 1

NAL means Net Advantage to Lease which is done by analyzing the lease alternative and buying alternative. This impact is shown in “Appendix A” and excel sheet which is named as “NAL & IRR”. For evaluating the Net Advantages lease, firstly, the lease alternative is analyzed. In the lease alternative, the lease payments are already given in the case which is $480,000 and adjusted tax benefits on the lease payment is $163,200. Furthermore, after the adjustment of lease Payment with tax benefits, it is analyzed through present value on the basis of the discounted rate of the bank with the adjustment of the tax shield which is 6.6%. The rate is discounted on the annuity basis from1 to 3 years. This would result in the present value of the computer cost of $837,496. On the other hand, the buying alternative, evaluates the loan amount which has to be borrowed from the bank at the interest rate of 10%. The loan installment is $603,172 per year and also the loan amortization schedule for extracting the tax benefit on the interest which is different from every year that is being prepared. Furthermore, the depreciation of cost from the MACRS method which is the new methodology for evaluating the perfect results of the purchasing assets that is being calculated. The depreciation is calculated for the tax advantage which covers the loan cost. After the calculation of the loan amount and the tax benefit, the project is evaluated on the basis of present value of the cost with adjustment of the tax benefits, which is $371,131. This present value shows the net impact on the lease which would be negative. The purchasing option is more suitable in the “Net Advantage to Lease”.

Moreover, moving to the “Internal Rate of Return” IRR, it is calculated through trial and error method in which the two discount rates is assumed. Therefore, two rates are taken, which are 4% and 10%, which are plugged into the IRR formula and yield an IRR of 4.1044%, which is the rate at which the future and present cash flows meets at zero NPV. All this analysis is done through the given data in the case material and financial management understanding.

  • Assume now that the bank loan would cost 15%, but the all other facts remain the same. What is NAL and IRR?

Answer 2

If the bank loan rate increases, then it would effect on both the sides of the present value, one is lease alternative and the second is buying alternative. The present value of lease alternative is decreased to $789,224 while for buying side, it has increased the present value to $441,245. There is no impact on the IRR, because IRR itself is calculated on the basis of present and future cash flows and therefore no change is made on the cash flow. This analysis is mentioned in “Appendix B” and also given in the excel sheet with the name “NAL and IRR 15%”

‘MEDICAL ASSOCIATES

Introduction

Medical Associates is a large group of companies which have good profitability. They have few queries relating to the capital structure and cost of capital. For the queries, they have mention such information on which it would be answered. The information and queries are given below.................

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