ROI and Leasing
The Malone Division of the Stoudt Corporation is organized as an investment center. Because of excellent operating results, the division manager, Terry Trocano, has been given considerable freedom in investment decisions. Terry knows that the top management of the Stoudt Corporation measures the performance of the operating divisions using an ROI criterion and that it is important for her to maintain a divisional ROI of 20% before taxes and 14% after taxes. Her annual bonus depends on achieving these targeted levels, and her compensation can increase considerably if she is able to obtain even higher ROIs.
Trocano has just completed a five-year forecast of annual operating performance for the Malone Division. The best estimate is that the current net investment level of $20,000,000 will be maintained over this period (that is, new investment will about equal the depreciation charge each year) and that the net income before taxes will be $4,000,000 and net income after taxes will be $2,800,000 each year.
Although Trocano is pleased that her forecasted results indicate that she will achieve both the before- and after-tax ROI targets, she is actively looking for projects that will enable her to exceed the targeted rates. A new investment proposal has recently emerged that seems particularly promising. The project requires an initial investment of $15,000,000 and will generate annual before-tax cash Hows of $6,000,000 for five years. The discounted cash flow analysis indicates that the project has a before-tax yield in excess of 28% and an after-tax yield of more than 19%. (The Stoudt Corporation has a marginal lax rate of 40% and uses sum-of-years-digits depreciation for computing taxable income.) Both of these yields are well in excess of the company's targeted ROI, so the proposed project seems like an excellent investment.
Before making a final decision on the $15,000,000 investment, Trocano has asked the division controller to forecast the first year's operating results for the Malone Division, including the income generated by the new project. She is surprised when she receives the following proforma results:
Before-Tax Analysis (000) | |
Net income from existing projects | $4,000 |
Cash flow—new project | 6,000 |
Less: Depreciation (straight-line, 5-year life) | (3,000) |
Net income | $7,000 |
Investment: Existing projects | $20,000 |
New project | 15,000 |
Total investment | $35,000 |
ROI | 20% |
qAfter-Tax Analysis (000) | |
Net income after taxes—existing projects | $ $ 2,800 |
Net income before tax—new project | 3,000 |
Taxes on new project* (sum-of-years-digits depreciation) | (400) |
Net income after taxes | $ 5,400 |
Total investment | 35,000 |
ROI | 15.4% |
*The company uses actual tax expense, based on the accelerated depreciation schedule, in allocating tax expense to divisions.
The project does not hurt the measured performance of the Malone Division, but it certainlv does not show the large increase in divisional ROI that Trocano had hoped for.
The controller proposes an alternative scheme for undertaking the investment. He has learned that another company is willing to acquire the buildings and equipment for the new project and lease them to the Malone Division at an annual rental payment of $5,200,000 for live years. The terms of the lease can be structured so that it is considered an operating lease and hence will not be capitalized on the Stoudt Corporation's financial statements. The controller has prepared the following proforma analysis of the lease option.
Before-Tax Analysis (000) | |
Net income from existing projects | $ 4,000 |
Cash flow—new project | 6,000 |
Less: Lease payment | (5,200) |
Net income | $4,800 |
Investment—existing projects | 20,000 |
ROI | 24% |
After-Tax Analysis (000) | |
Net income after taxes—existing projects | $ 2,800 |
Income from new project—net of lease payment | 800 |
Taxes—new project | (320) |
Net income after taxes | $ 3,280 |
Investment | 20,000 |
ROI | 16.4% |
The lease option seems much more attractive to Trocano, since it generates a significant increase in both before- and after-tax ROI for her division. She submits the proposed new project, with a recommendation to lease the new facilities, to the central administration staff. She expects a routine approval for this attractive investment opportunity.
Required
Assume that you are the newly hired assistant to the head of the corporate finance division and have been asked to review the project proposed from the Malone Division.
(1) Verify that the proposed project will yield the forecasted returns (more than 28% before tax and more than 19% after tax).
(2) Compute the before- and after-tax ROI for the Malone Division for each of the next five years for both the purchase and the lease options. The investment base for each year is the book value (using straight-line depreciation) of investment at the start of the year.
(3) At the company's after-tax cost of capital of 14%, is it better to purchase or lease the asset?
(4) Why does the leasing option generate higher ROI measures than the purchase option?
(5)Suggest an alternative scheme that will reduce the incentive to lease rather than to pur chase assets. Demonstrate how your scheme would work were the Malone Division to enter into the live-year lease with annual payments of $5,200,000
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