Question

Roberts Fabrication and Automation, Inc. (RFA) Roberts Fabrication and Automation, Inc. (RFA) just completed its Capital Budgeting analysis for a new metallic 3D printing machine that will aid in the design and production of new “classic” and custom automotive components. The NPV is positive and significant, the IRR is well above the 12% project hurdle rate (required return), and RFA has decided to move forward with the project.

The next part of their analysis involves the financing of the machine, that is, whether to purchase, or to lease the machine.

If the printer is purchased:

The initial investment (printer cost, shipping, & installation) is $347,500. RFA expects to borrow this amount from the 4th Tennessee Bank of the Southeast with a term of 4 years and an interest rate of 7.25%. The loan would be fully amortized and call for annual payments at the end of each year. Maintenance costs are predicted to be $20,000 per year. Base on Internal Revenue Service guidelines, the printer will be depreciated using MACRS (half-year convention) and a 5 year class-life. RFA’s tax rate is 31%

The Leasing option:

The printer will be made by Custom Tools of Middle Tennessee. It has offered to lease the printer to RFA as an alternative to the purchase option. Their proposed lease terms are:  Lease payments of $89,250 per year beginning on the installation of the printer with a total of 5 payments. (This means payments at t = 0, 1, 2, 3, and 4).  The Lease payments above include all maintenance.

RFA expects to operate this project for 4 years (and no more), regardless of whether is purchases or leases the printer. The printer is expected to have a market value of $42,500 (“salvage value”) at the end of the 4 year project. Consider this to be a guideline lease for IRS purposes.

Using a blank worksheet (or page of paper) conduct the Lease vs Buy analysis.

a. Using Custom Tools’ proposed lease terms, what is the NAL, and should the 3d printer be leased or purchased?

b. Using your first analysis (part a.), at what lease payment would the firm be indifferent to either leasing or buying? That is, what annual lease payment results in a NAL=0?

c. The salvage value is the most uncertain cash flow in the analysis. With the additional risk of that cash flow (assume a pre-tax discount rate of 15 percent for this item), what would be the effect of a salvage value risk adjustment on the decision? That is, what is the revised NAL, and decision in this scenario? Note: The salvage value is the only cash flow affected in this scenario.

Answer 1

Option 1 : Buy printer

   Initial investment : 347,500/-, Tenure 4 years, Rate of interest : 7.25%

Based on the above details monthly EMI is - 8361.68.

i.e. yearly payment of 100,340.22

Total payment under scheme will be : 100340.22*12 + 20000*4 (maintenance cost) - 42500 (salvage value) = 438,860/-

This cost is ignoring the tax benefit available on the interest payment

Option 2 : Total payment = 89250 * 5 = 446250

a) Based on the above options printer should be purchased

b) We should be indifferent only if cost from both the options are same, i.e. option1 = option 2

Hence option 2 final price should be 438860/4 = 87,772/-

c) With the pre-tax discount of 15% on the salvage value final cost of option 1 will be - 445,235.88/-