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 clss

2) Estimated maintenance expenses are $ 50,000

3) The firms's tax rate is 34%

4) If the money is borrowed, the bank loan will be at a rate of 14% 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 the 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 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, so Sadik would get to take the first depreciation expense oat year 3 ( the remaining depreciation expenses wold 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 starting at year 3.

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

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

Ans a) Sadik overall cost in terms of borrowing the machine will be EAIs of $2,57,157.50 which is an outflow from Year 1 to Year 6. This totals to be $ 15,42,944.97 (inclusive of interest and principal payments). There would also be maintenance cost of $50,000. Depreciation rate is not provided and neither does the salvage value so assuming entire machine has a useful life of Six years with no residual value then an yearly depreciation of $1,66,667 will be charged in P&L but we will be having a Tax Saving of 34% on the depreciation charged which we will be considering in our inflows. Thus Total Cost of Borrowing after providing net effect of Tax Saving should be $12,02,944.97.

Leasing on the other hand will have outflows in Year 1 to Year 3 annually $2,80,000.00 In year three the machine is purchased at $2,00,000 which is an outflow again. The inflows will be Tax saving of 34% on Depreciation of $50,000 charged for Year 3 to Year 6 this Tax Saving comes to $17,000.00. We would also add Maintenance Cost of $50,000.00. Thus total cost of Leasing is $9,72,000.00. So total savings under Cost of Leasing would be $2,30,944.97.

Ans b) With residual value of $2,00,000 at year 6 The depreciation amount would under go a change to $1,33,333 and Tax savings would change to $ 45,333. This would lead to cash outflow amount changing in all the Years with large cash inflow at Year 6 of $2,00,000, as per the cash flow calculations if the residual value would be increased by $99,00,000 then the leasing benefit would be nullify and borrowing would be a cheaper option.

Ans c) No, residual cash flow will be an inflow in year Six so higher the residual value the more it will favor the borrowing option. The cost of capital or the discount rate would determine the issue as higher cost of capital would take the NPV in case of borrowing into positive category given the cash flow structure.