Trasky Company is trying to decide whether it should purchase or lease a new aut

Question

Trasky Company is trying to decide whether it should purchase or lease a new automated machine to be used in the production of a new product. If purchased, the new machine would cost $100,000 and would be used for ten years. The salvage value at the end of ten years is estimated at $20,000. The machine would be depreciated using MACRS over a seven year period. The annual maintenance and operating costs would be $20,000. Annual revenues are estimated at $55,000.

If the machine is leased, the company would need to pay annual lease payments of $20,700. The first lease payment and a deposit of $5,000 are due immediately. The last lease payment is paid at the beginning of Year 10. The deposit is refundable at the end of the tenth year. In additional, under a normal contract, the company must pay for all maintenance and operating costs, although the leasing company does offer a service contract that will provide annual maintenance (on leased machines only). The contract must be paid up front and costs $30,000. Trasky estimates that the contract will reduce its annual maintenance and operating costs by $10,000. Trasky’s cost of capital is 14%. The tax rate is 40%. The service contract’s costs would e expensed over the 10 year period. Assume this is an operating lease.

a.Calculate the NPV for the purchase, lease without the service contract, and the lease with the service contract.

b.Which is the best alternative?

If anybody can help, thanks!

Explanation / Answer

Purchase decision Year Initial cost Revenues Maintenance& operating costs MACRS Depn. Rate Depn. Taxable Income Tax@ 40% Tax savings due to depn. Net annual cash flow Col.1 2 3 4 5 6 7=3-4-6 8=7*40% 9=6*40% 2+3-4-8+9 0 -100000 -100000 1 55000 20000 14.29 14290 20710 8284 5716 32432 2 55000 20000 24.49 24490 10510 4204 9796 40592 3 55000 20000 17.49 17490 17510 7004 6996 34992 4 55000 20000 12.49 12490 22510 9004 4996 30992 5 55000 20000 8.93 8930 26070 10428 3572 28144 6 55000 20000 8.92 8920 26080 10432 3568 28136 7 55000 20000 8.93 8930 26070 10428 3572 28144 8 55000 20000 4.46 4460 30540 12216 1784 24568 9 55000 20000 35000 14000 0 21000 10 55000 20000 35000 14000 0 21000 Purchase decision(contd) Year Net annual cash flow PV F @ 14% PV @ 14% 0 -100000 1 -100000 1 32432 0.87719 28449.03 2 40592 0.76947 31234.33 3 34992 0.67497 23618.55 4 30992 0.59208 18349.74 5 28144 0.51937 14617.15 6 28136 0.45559 12818.48 7 28144 0.39964 11247.47 8 24568 0.35056 8612.56 9 21000 0.30751 6457.71 10 21000 0.26974 5664.54 NET PRESENT VALUE OF 61069.55 PURCHASE OPTION Lease without service contract Year Annual Revenues Lease payments Maintenance& operating costs Taxable income Tax @40% Net annual cash flow PV F @ 14% PV @ 14% 0 5000 -5000 1 -5000 Deposit 0 20700 -20700 0 -20700 1 -20700 1 55000 20700 20000 14300 5720 8580 0.87719 7526.29 2 55000 20700 20000 14300 5720 8580 0.76947 6602.05 3 55000 20700 20000 14300 5720 8580 0.67497 5791.24 4 55000 20700 20000 14300 5720 8580 0.59208 5080.05 5 55000 20700 20000 14300 5720 8580 0.51937 4456.19 6 55000 20700 20000 14300 5720 8580 0.45559 3908.96 7 55000 20700 20000 14300 5720 8580 0.39964 3428.91 8 55000 20700 20000 14300 5720 8580 0.35056 3007.80 9 55000 20700 20000 14300 5720 8580 0.30751 2638.436 9 55000 20700 20000 14300 5720 8580 0.30751 2314.369 Beg. Of Year 10 10 55000 20000 35000 14000 21000 0.26974 5664.54 10 -5000 -5000 0.26974 -1348.7 Refund of deposit Net present value without service contract= 23370.15 Lease with service contract Year Annual Revenues Lease payments Maintenance& operating costs Taxable income Tax @40% Net annual cash flow PV F @ 14% PV @ 14% 0 30000 -30000 1 -30000 Upfront 0 20700 -20700 0 -20700 1 -20700 1 55000 20700 10000 24300 9720 14580 0.87719 12789.43 2 55000 20700 10000 24300 9720 14580 0.76947 11218.87 3 55000 20700 10000 24300 9720 14580 0.67497 9841.06 4 55000 20700 10000 24300 9720 14580 0.59208 8632.53 5 55000 20700 10000 24300 9720 14580 0.51937 7572.41 6 55000 20700 10000 24300 9720 14580 0.45559 6642.50 7 55000 20700 10000 24300 9720 14580 0.39964 5826.75 8 55000 20700 10000 24300 9720 14580 0.35056 5111.16 9 55000 20700 10000 24300 9720 14580 0.30751 4483.496 9 55000 20700 10000 24300 9720 14580 0.30751 3932.809 Beg. Of Year 10 10 55000 10000 45000 18000 27000 0.26974 7282.98 10 Net present value with service contract= 32634.01 a. NPV For Purchase 61069.55 For Lease without service contract 23370.15 For Lease with service contract 32634.01 b. Purchase is the best alternative as it returns greatest NPV

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