Lease analysis As part of its overall plant modernization and cost reduction pro
ID: 2612460 • Letter: L
Question
Lease analysis
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 found to be 20% versus a project 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 Tanner-Woods's marginal federal-plus-state tax rate is 40%. The applicable MACRS rates are 20%, 32%, 19%, 12%, 11%, and 6%.
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 and servicing. Actually, the loom has an expected life of 8 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 an 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?
-Select-shoud be leasedshould be purchasedItem 1
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%. Should the loom in this case be leased or purchased?
-Select-shoud be leasedshould be purchasedItem 2
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 it 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?
-Select-Tanner-Woods shoud lease the loom, whether differential salvage value risk is considered or not.Tanner-Woods shoud purchase the loom, whether differential salvage value risk is considered or not.The decision would remain the same.Item 3
Lease analysis
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 found to be 20% versus a project 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 Tanner-Woods's marginal federal-plus-state tax rate is 40%. The applicable MACRS rates are 20%, 32%, 19%, 12%, 11%, and 6%.
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 and servicing. Actually, the loom has an expected life of 8 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 an 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?
-Select-shoud be leasedshould be purchasedItem 1
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%. Should the loom in this case be leased or purchased?
-Select-shoud be leasedshould be purchasedItem 2
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 it 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?
-Select-Tanner-Woods shoud lease the loom, whether differential salvage value risk is considered or not.Tanner-Woods shoud purchase the loom, whether differential salvage value risk is considered or not.The decision would remain the same.Item 3
Explanation / Answer
Answer:a
a. 0 1 2 3 4
| | | | |
Net purchase price (250,000)
Depr’n tax savingsa 20,000 32,000 19,000 12,000
Maintenance (AT) (12,000) (12,000) (12,000) (12,000)
Salvage value 42,500
Net cash flow (250,000) 8,000 20,000 7,000 42,500
PV cost of owning at 6% = -$185,112.
Notes:
1. There is no tax associated with the loom’s salvage value since salvage value equals book value.
2. The appropriate discount rate is the after-tax cost of debt =
kd(1 - T) = 10%(1 - 0.4) = 6%.
a Depreciation tax savings are calculated as follows:
Depreciation Schedule
MACRS
Allowance *Depreciation End of Year Depreciation
Year Factor Expense Book Value Tax Savings
1 0.20 $50,000 $200,000 $20,000
2 0.32 80,000 120,000 32,000
3 0.19 47,500 72,500 19,000
4 0.12 30,000 42,500 12,000
*Note that the loom’s depreciable basis is $250,000.
The cost of leasing can be placed on a time line as follows:
0 1 2 3 4
| | | | |
Lease payment (AT) -42,000 -42,000 -42,000 -42,000 -42,000
PV at 6% = -$187,534.
Thus, the present value of the cost of owning is $187,534 - $185,112 = $2,422 less than the present value of the cost of leasing. Tanner-Woods Textile should purchase the loom.
b. Here we merely discount all cash flows in the cost of owning analysis at 6 percent except the salvage value cash flow, which we discount at 9 percent, the after-tax discount rate (15%(1 - 0.4)):
0 1 2 3 4
| | | | |
($250,000) PVs of all other cash flows
7,547 @ 6%
17,800
5,877
0
30,108 @ 9% $42,500
NPV = (188,668)
When differential risk is considered, the cost of owning is now higher than the $187,534 cost of leasing; thus, the firm should lease the loom.
c. This merely shifts the salvage value cash flow from the cost of owning analysis to the cost of leasing analysis. If Tanner-Woods Textile needed the loom after four years, it would have it if the loom were purchased, but would have to buy it if the loom were leased. The decision would remain the same. If differential salvage value risk is not considered, the loom should be purchased. In fact, the advantage to purchasing would be exactly the same.
.
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