- Sadik Industries must install $1 million of new machinery in its Texas
plant. It can obtain a bank loan for 100% of the required amount. Alternately, a Texas investment banking firm which represents a group of investors believes that it can arrange for a lease financing plan. Assume that these facts apply:
1) The equipment falls in the MACRS 3-year class.
2) Estimated maintenance expenses are $50,000 per year.
3) The firm’s tax rate is 33%.
4) If the money is borrowed, the bank loan will be at a rate of 14%, amortized in
3 equal installments at the end of each year.
5) The tentative lease terms call for payments of $320,000 at the end of each
year for 3 years. The lease is a guideline lease.
6) Under the proposed lease terms, the lessee must pay for insurance, property
taxes, and maintenance.
7) Sadik must use the equipment if it is to continue in business, so it will almost certainly want to acquire the property at the end of the lease. If it does, then under the lease terms it can purchase the machinery at its fair market value at that time. The best estimate of this market value is $200,000, but it could be much higher or lower under certain circumstances.
To assist management in making the proper lease-versus-buy decision, you are asked to answer the following questions:
- Assuming that the lease can be arranged, should the firm lease or borrow and buy the equipment? (Hint: In this situation, the firm plans to use the asset beyond the term of the lease. Thus, the residual value becomes a cost to leasing in Year 3. Also, there is no Year 3 residual value tax consequence, as the firm cannot immediately deduct the Tear 3 purchase price from taxable income).
- Consider the $170,000 estimated residual value. Is it appropriate to discount it at the same rate as the other cash flows? What about the other cash flows – are they all equally risky? (Hint: Riskier cash flows are normally discounted at higher rates, but when the cash flows are costs rather than inflows, the normal procedure must be reversed).
we have been provided with the information as follow
| Borrow and Buy Decision | ||||
| Loan Amount | 1,000,000 | |||
| Repayment | 3 | years | ||
| Interest rate | 14% | |||
| Cost of Capital | 9.38% | |||
| Loan Instalment | ($430,731.48) | |||
| Tax rate | 33% | |||
| Depreciation Schedule | ||||
| Year 1 | 33.33% | |||
| Year 2 | 44.45% | |||
| Year 3 | 14.81% |
Now we will make loan amortization schedule as follow
| Loan Amortization Schedule | |||||
| year | Beginning Amount | Installment | Interest | Principle repayment | Ending Loan |
| 1 | $ 1,000,000 | $ 430,731 | $ 140,000 | $ 290,731 | $ 709,269 |
| 2 | $ 709,269 | $ 430,731 | $ 99,298 | $ 331,434 | $ 377,835 |
| 3 | $ 377,835 | $ 430,731 | $ 52,897 | $ 377,835 | $ 0 |
Now we will calculate the present value under the both the option as follow
| Cost of Borrowing and owning | |||||
| Year | 0 | 1 | 2 | 3 | |
| Loan Payment | $430,731.48 | $430,731.48 | $430,731.48 | ||
| Interest | $ 140,000 | $ 99,298 | $ 52,897 | ||
| tax savings on Interest | $ 46,200.00 | $ 32,768.21 | $ 17,455.96 | ||
| Depreciation | 333300 | 444500 | 148100 | ||
| tax savings on depreciation | 109989 | 146685 | 48873 | ||
| Net cash Flow | $ 274,542.48 | $251,278.27 | $ 364,402.52 | ||
| PV Cost of Owning | $739,490.79 |
| Cost of Leasing | |||||
| Year | 0 | 1 | 2 | 3 | |
| Lease payment | 320,000 | 320,000 | 320,000 | ||
| Tax savings on lease payment | 105600 | 105600 | 105600 | ||
| market Value of Machine | 200,000 | ||||
| Net cash flow | 214,400 | 214,400 | 414,400 | ||
| PV Cost of leasing | $691,887.73 | ||||
Since PV cost of leasing is lower, lease the machine.
Note: as maintainenace and other expenses are paid under purchase as well as lease options, these costs are irrelevant for decesion Making
B
For a risk averase decision maker it makes sense to discount more risky cash flows inflows at a higher discount rate but risky future cash inflows at a lower discount rate. The residual value is the value which company will have to pay to buy the equipment for future use at the end of lease term. The risk associated with this is much higher. But as this is not a cash inflow but a cash outflow so we would prefer using a lower rate as using a higher rate would make the lease look more attractive. Hence use of lower rate is justified.
