Question

Part 7
Big Al’s currently leases its equipment from Pizza Products for $2,500 per month. Two years of the five-year lease term remain. Big Al’s can terminate the lease at any time by paying a penalty of $10,000. Big Al’s is considering purchasing equipment to replace the leased equipment. Big Al’s must purchase 10 units of each piece of equipment. Big Al’s can purchase equipment at the following prices:

Equipment Price (per unit)
Dough ball press $5,450
Assembly table 2,100
Cardboard cutter 4,100
Plastic sealer 2,695
Label installer 1,000

Required:
A. Using NPV analysis, compare the present value of the lease payments with the cost of buying the equipment. Assuming a discount rate of 10 percent (before tax), which option is preferable?
B. Big Al’s has the option of purchasing equipment from another supplier at a cost of $190,000. The supplier promises that the new equipment will reduce operating costs by $1,000 per month over the life of the equipment. Assuming a
10 percent discount rate (before tax), which option is preferable?
C. Calculate the after-tax NPV for each option discussed previously. If purchased, all equipment will be depreciated over five years, using straight-line depreciation, and will have no salvage value. Big Al’s tax rate is 30 percent. Is your decision still the same?
D. What factors other than cost savings should Big Al’s consider in these decision problems?

Answer 1

ANSWER

First, calculate the present value of the lease payments as follows: End of Year 2 Cash outflows 30,000 30,000 30,000 30,000 30,000 PV factor @ 10% 0.909 0.826 0.751 0.683 0.621 Net present value 27,270 24,780 22,530 20,490 18,630 113.700 Net present value Then, calculate the cost of buying the equipment as follows: Particulars Heater (2100x10) Injection (5450x10) Sealer (4100x10) Cutter (2695x10) Installer (1000x10) Penalty Cost of buying Amount 21,000 54,500 41,000 26,950 10,000 10,000 163.450 As per the calculations, it can be concluded that don't buy the equipment 2. First, calculate the present value of reduce operating costs as follows: End of Year PV factor @ 10% Net present value reduce operating costs 12,000 12,000 12,000 12.000 12,000 0.909 0.826 0.751 0.683 0.621 10.908 9,912 9,012 8,196 7,452 45,480 Net present value Then, calculate the net cost of buying the equipment as follows: Particulars Cost of equipment Savings in operating costs Net cost of buying present value of the lease payments Amount 190,000 45,480 144,520 113,700 As per the calculations, it can be concluded that don't buy the equipment. Calculate the after-tax NPV as follows: Lease End of Year Cash outflows 30,000 30.000 30.000 30,000 30.000 PV factor @ 10% 0.909 0.826 0.751 0.683 0.621 | Net present value 27,270 24,780 22,530 20,490 18.630 113,700 Net present value Purchase from Quality Materials Particulars Initial investment Less: Tax savings (30,690x 3.791x30%) Net present value Amount 153,450 34,904 118,546 Purchase for $190,000 Particulars Initial investment Savings in operating costs Less: Tax savings (30,690x 3.791x30%) Net present value Amount 190,000 45,480 34.904 109.616 The most preferable option is Purchase for $190,000. Factors other than cost savings should Big Al's consider are as follows • Availability of funds • Demand of the products

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