Suppose Procter and Gamble? (P&G) is considering purchasing $10 million in new m

Question

Suppose Procter and Gamble? (P&G) is considering purchasing

$10

million in new manufacturing equipment. If it purchases the? equipment, it will depreciate it on a?straight-line basis over the five? years, after which the equipment will be worthless. It will also be responsible for maintenance expenses of

$1.75

million per year.?Alternatively, it can lease the equipment for??

$2.3

million per year for the five? years, in which case the lessor will provide necessary maintenance. Assume? P&G?s tax rate is

35%

and its borrowing cost is

7.5%.

a. What is the NPV associated with leasing the equipment versus financing it with the lease equivalent? loan?

b. What is the? break-even lease

ratelong dash—that

?is, what lease amount could? P&G pay each year and be indifferent between leasing and financing a? purchase?

Explanation / Answer

a) PV OF OWNING: Discount rate = 7.5*(1-0.35) = 4.88% Loan amortization: ` Annual installments due at the end of the year = 10000000*0.075*1.075^5/(1.075^5-1) = $            24,71,647 Amortization table: 0 1 2 3 4 5 Beginning loan balance 10000000 8278353 6427582 4438004 2299207 Interest at 7.5% 750000 620876 482069 332850 172441 Total 10750000 8899229 6909651 4770854 2471648 Less: Installment payment 2471647 2471647 2471647 2471647 2471647 Ending loan balance 8278353 6427582 4438004 229921 1 After tax interest (Interest*0.65) 487500 403570 313345 216353 112086 Repayment of principal 1721647 1850771 1989578 2138797 2299206 Depreciation (10000000/5) 2000000 2000000 2000000 2000000 2000000 The PV of owning is calculated in the table below: Principal repayment 1721647 -1850771 -1989578 -2138797 -4257499 After tax interest -487500 -403570 -313345 -216353 -1420767 Tax shield on depreciation at 35% 700000 700000 700000 700000 700000 After tax maintenance costs (1750000*0.65) -1137500 -1137500 -1137500 -1137500 -1137500 Net cash flows 796647 -2691840 -2740423 -2792649 -6115766 PVIF at 4.88% 1 0.95347 0.90911 0.86681 0.82647 0.78802 4.34388 PV at 4.88% 759580 -2447169 -2375415 -2308053 -4819339 PV OF OWNING $          -63,71,057 PV OF LEASING: After tax lease payments = 2300000*(1-0.35) = $            14,95,000 PV of leasing = -1495000*(1.0488^5-1)/ (0.0488*1.0488^5) = $          -64,94,095 NET ADVANTAGE OF LEASING: PV of leasing $          -64,94,095 Less: PV of owning $          -63,71,057 NET ADVANTAGE OF LEASING: $            -1,23,037 As owning has lower PV of net cash outflows, it is advantageous to own the equipment. b) Break even lease rent = 6371057/PVIFA(4.88,5) = = 6371057/4.34388 = $      14,66,674.26

Related Questions

Navigate

• Browse (All)
• Browse S
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.