Question

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 it can arrange for a lease financing plan. Assume that the following 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 34%.
(4) If the money is borrowed, the bank loan will be at a rate of 14%, amortized in three 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 Year 3. The best estimate of this market value is $200,000, 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.

To assist management in making the proper lease-versus-buy decision, you are asked to answer the following.

a. What is the net advantage of leasing? Should Sadik take the lease?

b. Consider the $200,000 estimated residual value. How high could the residual value get

before the net advantage of leasing falls to zero?

c. The decision almost can be considered a bet on the future residual value. Do you think

the residual cash flows are equal in risk to the other cash flows? If not, how might you address

this issue? ( Hint:   if you discount a negative cash flow at a higher rate, you get a better NPV

� the NPV of a negative cash flow stream is less negative at high discount rates.)

Answer 1

		PURCHASE OPTION
		Equipment Cost	$1,000,000
		3 year MACRS
		Equipment Cost=$1000000	$1,000,000			TAX RATE=34%
			A	B=A*$1000000	C	D=B*34%
			Depreciation	Amount of	Accumulated	Depreciation
		Year	Rate	Depreciation	Depreciation	Tax Shield
		1	33.33%	$333,300	$333,300	$69,993
		2	44.45%	$444,500	$777,800	$93,345
		3	14.81%	$148,100	$925,900	$31,101
		4	7.41%	$74,100	$1,000,000	$15,561
		After tax cost of debt =14*(1-0.34)	9.24%
		Discount Rate =9.24%=0.0924
		INTEREST AND PRINCIPAL REPAYMENT ON AMOUNT BORROWED
	Pv	Amount Borrowed =	$1,000,000
	Nper	Number of years of repayment	3
	Rate	Interest Rate	14%
	PMT	Annual repayment in three equal instalments	$430,731	(Using PMT function of excelwith Rate=14%,Nper=3, Pv=-1000000)
		REPAYMENT SCHEDULE
		Year		1	2	3
	A	Beginning Balance		$1,000,000	$709,269	$377,835
	B	Amount of annual payment		$430,731	$430,731	$430,731
	C=A*14%	Interest		$140,000	$99,298	$52,897
	D=B-C	Principal		$290,731	$331,434	$377,835
	E=A-D	Ending Balance		$709,269	$377,835	$0
	F=C*34%	Interest Tax Shield		$47,600	$33,761	$17,985
	N	Year	0	1	2	3	4	5	6
		Annual Cash Inflows:
	.(1)	Cash Flow for annual repayment		-$430,731	-$430,731	-$430,731	$0	$0	$0
	.(2)	Depreciation Tax shield		$69,993	$93,345	$31,101	$15,561	$0	$0
	.(3)	Interest Tax Shield		$47,600	$33,761	$17,985	$0	$0	$0
	CF=(1)+(2)+(3)	Net Cash Flow		-$313,138	-$303,625	-$381,646	$15,561	$0	$0	SUM
	PV=CF/(1.0924^N)	Present Value of Cash Flow at discount rate9.24%		-$286,652	-$254,434	-$292,762	$10,927	$0	$0	-$822,921
		NET PRESENT VALUE(NPV)	-$822,921
		LEASE OPTION
		After tax lease payment =320000*(1-0.34)	$211,200
	N	Year	0	1	2	3	4	5	6
	.(1)	After Tax Lease Payment		-$211,200	-$211,200	-$211,200	$0	$0	$0
	.(2)	Terminal Payment				($200,000)
	a	MACRS Depreciation rate				33.33%	44.45%	14.81%	7.41%
	b=a*200000	Annual Depreciation				$66,660	$88,900	$29,620	$14,820
	c=b*34%	Depreciation Tax shield				$22,664	$30,226	$10,071	$5,039
	CF=(1).+(2)+c	Net Cash Flow		-$211,200	-$211,200	-$388,536	$30,226	$10,071	$5,039	SUM
	PV=CF/(1.0924^N)	Present Value of Cash Flow at discount rate9.24%		-$193,336	-$176,983	-$298,048	$21,225	$6,474	$2,965	-$637,702
		NET PRESENT VALUE(NPV)	-$637,702
		LEASE OPTION IS RECOMMENDED
		NPV of Cost is Lower
		Net Advantage of Leasing=822921-637702	$185,219
											H18 - X for =PMT(H17,H16,-H15) $1,000,000 PURCHASE OPTION Equipment Cost 3 year MACRS Equipment Cost=$1000000 $1,000,000 Depreciation Rate 33.33% 44.45% 14.81% 7.41% TAX RATE=34% B=A*$1000000 C D=B*34% Amount of Accumulated Depreciation Depreciation Depreciation Tax Shield $333,300 $333,300 $69,993 $444,500 $777,800 $93,345 $148,100 $925,900 $31,101 $74,100 $1,000,000 $15,561 14 15 Pv 16 Nper 17 Rate 18 PMT INTEREST AND PRINCIPAL REPAYMENT ON AMOUNT BORROWED Amount Borrowed = $1,000,000 Number of years of repayment Interest Rate 14% Annual repayment in three equal instalments $430,731 (Using PMT function of excelwith Rate=14%, Nper=3, Pv=-1000000) 4 2 $211,200 6 $0 -$211,200 $0 $0 LEASE OPTION After tax lease payment =320000*(1-0.34) $211,200 Year After Tax Lease Payment Terminal Payment MACRS Depreciation rate Annual Depreciation Depreciation Tax shield Net Cash Flow Present Value of Cash Flow at discount rate9.24% NET PRESENT VALUE(NPV) $822,710 Estimated Residual value should be $472,000 before the net advantage of leasing falls to zero $211,200 ($472,000) 33.33% $157,318 $53,488 $629,712 -$483,055 44.45% $88,900 $30,226 $30,226 $21,225 14.81% $29,620 $10,071 $10,071 $6,474 7.41% $14,820 $5,039 $5,039 SUM $2,965 -$211,200 $193,336 $211,200 $176,983 $822,710