Lease Financing

Instructions

INSTRUCTIONS

1. This assignment is worth 10 points.

2. It is due 11:59pm, Apr 24, Thursday. You can have a 1-day grace period with an upfront loss of 2 points. Submission later than 11:59 pm, Apr 25 will not be accepted.

3. Use Excel functions, formulas and cell reference to fill in the colored cells to complete the work.

4. After completing the work, upload the Excel file to Blackboard.

Leasing

Chapter:19Problem:6

As part of its overall plant modernization and cost reduction program, Western Fabrics' management has decided to install a new automated weaving loom. In the capital budgeting analysis of this equipment, the IRR of the project was found to be 20% versus the project's required return of 12%.

The loom has an invoice price of $250,000, including delivery and installation charges. The funds needed could be borrowed from the bank through a 4-year amortized loan at a 10% interest rate, with payments to be made at the end of each year. In the event that the loom is purchased, the manufacturer will contract to maintain and service it for a fee of $20,000 per year paid at the end of each year. The loom falls in the MACRS 5-year class, and Western's marginal federal-plus-state tax rate is 40%.

Gardial Automation Inc., maker of the loom, has offered to lease the loom to Westen for $70,000 upon delivery and installation (at t=0) plus 4 additional annual lease payments of $70,000 to be made at the ends of Years 1 through 4. (Note that there are 5 lease payments in total.) The lease agreement includes maintenance and servicing. Actually, the loom has an expected life of eight years, at which time its expected salvage value is zero; however, after 4 years, its market value is expected to equal its book value of $42,500. Tanner-Woods plans to build and entirely new plant in 4 years, so it has no interest in either leasing or owning the proposed loom for more than that period.

a. Should the loom be leased or purchased?

First, we want to lay out all of the input data in the problem.

INPUT DATA

Invoice Price$250,000Length of loan4Loan Interest rate10%Maintenance fee$20,000Tax Rate40%Lease fee$70,000Equipment expected life8Expected salvage value$0Market value after 4 years$42,500Book value after 4 years$42,500

First, we can determine the annual loan payment that must be made on the new equipment. We will do so using thefunction wizard for PMT.

Annual loan payment =$78,868
1461: You can use Excel's PMT function

Year1234Beginning loan balance$250,000$196,132$136,878$71,698Interest payment$25,000$19,613$13,688$7,170Principal payment$53,868$59,254$65,180$71,698Ending loan balance$196,132$136,878$71,698$0

Now, we see that the decision being made is whether to purchase the equipment at a net cost of $250,000 (with annual payments of $78,868) or lease the equipment and make annual payments of $70,000. To make this decision, we must analyze the incremental cash flows.

Before proceeding with our NPV analysis we must determine the schedule of depreciation charges for this new equipment.

MACRS 5-year Depreciation ScheduleYear123456Depr. Rate20.00%32.00%19.20%11.52%11.52%5.76%Depr. Exp.$50,000$80,000$48,000$28,800$28,800$14,400

We can now construct our table of incremental cash flows from these two alternatives. Remember, that the appropriate discount rate in this scenario is the after tax cost of borrowing, or: 10%*(1-40%) = 6%.

0.06NPV LEASE ANALYSIS OF INCREMENTAL CASH FLOWS

Year =01234 Cost of ownershipPurchase cost($250,000)Loan proceeds$250,000After-tax interest payment($15,000)($11,768)($8,213)($4,301.87)Principal payment($53,868)($59,254)($65,180)($71,698)Maintenance cost($20,000)($20,000)($20,000)($20,000)Tax savings from maintenance cost$8,000$8,000$8,000$8,000Tax savings from depreciation$20,000$32,000$19,200$11,520Salvage value$42,500Net cash flow from ownership$0($60,868)($51,022)($66,193)($33,980)PV cost of ownership($185,323.87)

Cost of leasingLease payment($70,000)($70,000)($70,000)($70,000)($70,000)Tax savings from lease payment$28,000$28,000$28,000$28,000$28,000Net cash flow from leasing($42,000)($42,000)($42,000)($42,000)($42,000)PV cost of leasing($187,534.44)

Cost ComparisonPV ownership cost @ 6%($185,324)PV of leasing @ 6%($187,534)Net Advantage to Leasing($2,211)

What is your suggestion, owning or leasing?Owning since NAL is negative

b. The salvage value is clearly the most uncertain cash flow in the analysis. Assume that the appropriate salvage value pre-tax discount rate is 15 percent. What would be the effect of a salvage value risk adjustment on the decision?

All cash flows would remain unchanged except that of the salvage value. Our new array of cash flows would resemble thefollowing:

Standard discount rate10%0.06Salvage value rate15%0.09Operating cash Salvage value cash Year =01234
Eugene Brigham: Operating cash flows for t=4.4
Eugene Brigham: Salvage value cash flow in t=4.Net cash flow$0($60,868)($51,022)($66,193)($76,480)$42,500PV of net cash flows$0($57,422)($45,410)($55,577)($60,579)$30,108

NPV of ownership($188,880)

New Cost ComparisonPV ownership cost @ 6%($188,880)PV of leasing @ 6%($187,534)Net Advantage to Leasing$1,345

Now what do you say?Buying since NAL is positive

c. Assuming that the after-tax cost of debt should be used to discount all anticipated cash flows, at what lease payment would the firm be indifferent to either leasing or buying?

Hint: Use the Goal Seek function to determine the lease payment that makes the Net Advantage to Leasing zero.

Crossover =$70,502Used what if analysis - set C117, to value 0, by changing C36

Sheet1loan amount100,000term in mos180interest rate7.0%payment($900.00)