As part of its overall plant modernization and cost reduction program, the manag
ID: 2485080 • Letter: A
Question
As part of its overall plant modernization and cost reduction program, the management of Tanner-Woods Textile Mills has decided to install a new automated weaving loom. In the capital budgeting analysis of this equipment, the IRR of the project was 20% versus a project required return of 12%. The loom has an invoice price of $260,000, including delivery and installation charges. The funds needed could be borrowed from the bank through a 4-year amortized loan at a 8% interest rate, with payments to be made at year-end. In the event the loom is purchased, the manufacturer will contract to maintain and service it for a fee of $20,000 per year paid at year-end. The loom falls in the MACRS 5-year class, and Tanner-Woods's marginal federal-plus-state tax rate is 40%. The applicable MACRS rates are 19%, 34%, 17%, 13%, 11%, and 7%. United Automation Inc., maker of the loom, has offered to lease the loom to Tanner-Woods for $70,000 upon delivery and installation (at t = 0) plus 4 additional annual lease payments of $70,000 to be made at the end of Years 1 through 4. (Note that there are 5 lease payments in total.) The lease agreement includes maintenance servicing. Actually, the loom has an expected life of 10 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 $44,000. Tanner-Woods plans to build an entirely new plant in 4 years, so it has no interest in leasing or owning the proposed loom for more than that period. Round your answers to the nearest dollar. a.Should the loom be leased or purchased? PV cost of owning at 4.8% is $ . PV cost of leasing at 4.8% is $ . Tanner-Woods Textile should -Select-purchaselease the loom. b.The salvage value is clearly the most uncertain cash flow in the analysis. Assume that the appropriate salvage value pretax discount rate is 14%. What would be the effect of a salvage value risk adjustment on the decision? Round your answer to the nearest dollar. NPV is $ . The firm should -Select-purchaselease the loom. c.The original analysis assumed that Tanner-Woods would not need the loom after 4 years. Now assume that the firm will continue to use the loom after the lease expires. Thus, if it leased, Tanner-Woods would have to buy the asset after 4 years at the then existing market value, which is assumed to equal the book value. What effect would this requirement have on the basic analysis? (No numerical analysis is required; just verbalize.) The firm would choose to -Select-ownlease as the net advantage.
Explanation / Answer
I Option of obtaining a Bank Loan 260000=(PMT*(1-(1+0.048)^-4)/0.048) PMT= 72982.7 Year Tow.Principal Tow. Interest Annual Instalment Balance Pending 0 260000 1 60503 12480 72983 199497 2 63407 9576 72983 136090 3 66450 6532 72983 69640 4 69640 3343 72983 0 260000 31931 PV of OWNING Year Tax shield for O&M by contractor@ 40% MACRS Depn. Tax shield Total Savings PV F @ 4.8% PV Of savings 0 1 1 8000 19760 27760 0.9542 26489 2 8000 35360 43360 0.91049 39479 3 8000 17680 25680 0.86879 22311 4 8000 13520 21520 0.829 17840 106118 Purchase cost 260000 Total PV of Owning(Cost-Savings) 153882 Total PV of Owning(Cost-Savings) 153882 After TaxPV of Leasing =42000+(42000*3.56248) 191624 NPV of leasing -37742 As the Net Present Value is negative , it is more beneficial to buy than to lease the asset. NOTE: As the firm has decided to replace the loom regardless of whether the firm leases or purchases, it is not relevant for decision making and hence not considered for calculations under both , except for depreciation tax shield c. Salvage @ Year 4 @ (14*(1-40%))= 44000*8.4%= 3696 PV of Salvage 3696*0.829= 3063.98 Total PV of Owning(Cost-Savings) 153882 Less: PV of Salvage 3696*0.829= 3063.98 PV of owning 150818 NPV of Leasing Increases -40806 If the firm chooses to buy the asset after 4 years at the then existing market value, which is assumed to equal the book value. Following points will be there: Cash outflow @ 4 th Year for 44000 Remaining 17% MACRS depreciation can be availed for years 5&6 & hence tax shield.
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