Question

Excel Online Structured Activity: Lease versus Buy 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. Alternatively, a Texas investment banking firm that 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 $56,000 per year. 3. The firm's tax rate is 40%. 4. If the money is borrowed, the bank loan will be at a rate of 15%, amortized in six equal installments at the end of each year. 5. The tentative lease terms call for payments of $280,000 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 Year 3. The best estimate of this market value is $180,000, but it could be much higher or lower under certain circumstances. If purchased at Year 3, the used equipment would fall into the MACRS 3-year class. Sadik would actually be able to make the purchase on the last day of the year (i.e., slightly before Year 3), so Sadik would get to take the first depreciation expense at Year 3 (the remaining depreciation expenses would be at Year 4 through Year 6). On the time line, Sadik would show the cost of the used equipment at Year 3 and its depreciation expenses starting at Year 3. Year 3-year MACRS 33.33 % 1 44.45 % 2

please this question is giving me problem. please help me to solve for it .please

Answer 1

In Buy Vs Lease model, as per the provided details Buy option seems to be better options. As per Lease NPV of cashflow is 882 whereas NPV of cashflow in case of buy is 717. Hence in case of buy cost is lower.

Parameters Figs in $ '000 1000 Cost of Machine Maintenace 56 Rate of Interest 15% Lease per year CCA/ Dep 280 0.2 Life of Machine 6 Salvage after 5 years Tax Benefit 0.4 Solution Year Details 0 1 2 3 4 5 6 Depreciation rate Cost of Machine (a) Market value (after 3 years) Lease per year (c) Cost Of Capital(d)= (d)*(c) Lease ('e Maintenance Cost(f1) Interest(f2) Depreciation(f3) Cash Flow (g)= (d)+('e)+(fn) Tax Benefit (h)= 40% of (g) Net Cash flow(g+h) NVP of Cash flow Cumulative Asset Value 7.4% 33.3% Lease 44.5% 14.8% 1000 0 280 15% 280 280 280 56 56 56 56 56 56 27 27 27 333 445 148 74 280 336 336 669 528 231 157 40% -134 -134 -268 -211 -92 -63 202 202 402 317 139 94 175 152 264 181 69 41 175 328 592 773 842 882

Solution Year 0 1 2 4 5 6 NPV Depreciation rate(Dep) Cost of Machine (a) Interest(b)= As per EMI Calculator Annual Maintenace Cost CCA Depreciation ('e) =(a)*(Dep) Cash Flow (g)=(d)+('e)+(f) Tax Benefit (h)= (h)*((d)+('e) Net Cash flow NVP of Cash flow 33.3% 44.5% 14.8% 7.4% 1000 15% 150 133 113 90 64 34 56 56 56 56 56 56 Borrow 333 445 148 74 206 189 502 591 269 165 40% -76 -82 201 236 -107 -66 124 113 301 355 161 99 107 86 198 203 80 43 717

Payment Schedule for 6 Years Total Outstanding Loan - (b) Outstanding Loan 1,000 1,585 585 (a) (b) (c) EMI Principal Interest Month Year 1,000.0 885.8 1 264.2 114.2 150.0 2 264.2 131.4 132.9 754.4 113.2 1 264.2 151.1 1 4 603.3 264.2 173.7 90.5 1 429.6 264.2 199.8 64.4 1 6 229.8 264.2 229.8 34.5 1 7 L CO

Question 1) Net Advantage of Lease is 118 (1000- 882). Shadik should go for buy model as explained above