Morris-Meyer Mining Company must install $1.5 million of new machinery in its Ne

Question

Morris-Meyer Mining Company must install $1.5 million of new machinery in its Nevada mine. It can obtain a bank loan for 100% of the required amount. Alternatively, A Nevada investment banking firm that represents a group of investors believe that it can arrange for a lease financing plan. Assume the following facts apply:
1. The equipment falls in the MACRS 3-year class. The applicable MACRS rates are 33%, 45%, 15%, and 7%.
2. Estimated maintenance expenses are $75,000 per year.
3. Morris-Meyer’s Federal-plus-state tax rate is 40%.
4. If the money is borrowed, the bank loan will be at a rate of 15%, amortized in 4 equal installments to be paid at the end of each year.
5. The tentative lease terms call for end-of-year payments of $400,000 per year for 4 years.
6. Under the proposed lease terms, the lessee must pay for insurance, property taxes, and maintenance.
7. Morris-Meyer must use the equipment if it is to continue in business, so it will almost certainly want to acquire the property at the end of the lease, If it does, then the lease terms, it can purchase the machinery at its fair market value at that time. The best estimate of this market value is $250,000 salvage value, but it may be much higher or lower under certain circumstances.
To assist management in making the proper lease-versus-buy decision, you are asked to answer the following questions:
a. Assuming that the lease can be arrange, should Morris-Meyer lease or borrow and buy the equipment? Explain.
b. Consider the $250,000 estimated salvage value. Is it appropriate to discount it at the same rate as the other cash flows? W hat about the other cash flows-are they all equally risky? Explain. (Hint: Riskier cash flows are normally discounted at higher rates; but when the cash flows are costs rather than inflows, the normal procedure must be reversed.)

Explanation / Answer

a.        Year0 Year1 Year2 Year3 Cost of Owning: Net Purchased price (1,500,000) Depreciation savings $198,000 $270,000 $90,000 Net cash flow (1,500,000) $198,000 $270,000 $90,000 PV of cost owning at 9% ($991,845) Cost of Leasing: Lease payment (240,000) (240,000) (240,000) Purchase price option Net cash flow $198,000 $270,000 $90,000 PV cost of leasing @9% ($954,639)    Net advantage to lease    = PV of cost of owning - PV of cost of leasing                                           =   $991,845 - $954,639                                           =$37,206    Cost of new machinery   = $1,500,000 Year MACRS factor Depreciation Depreciation tax savings 1 0.33 $495,000 $198,000 2 0.45 675,000 $270,000 3 0.15 225,000 $90,000 4 0.07 105,000 $42,000 Leasing costs are less when compare to Owing. Therefore we should go for lease. (Note:Depreciation is a non-cash charge, so its only cash flow effect is the tax savings it provides.) b. Suppose if we assume that firm will buy equipment at the end of 4 years including the leasing plan hence $250,000 is added cost under leasing. Lower rate to penalize the lease decision makes sense because residual value uncertainties increase the uncertainty operations under lease alternative. Generally, the risk-averse decision makers make intuitive sense to discount riskier future inflows at higher rate but risky future outflows at a lower rate. The cash flows for borrowing and leasing except for residual value cash flow are certain relatively because they are fixed by contract and hence are not very risky.           Year0 Year1 Year2 Year3 Cost of Owning: Net Purchased price (1,500,000) Depreciation savings $198,000 $270,000 $90,000 Net cash flow (1,500,000) $198,000 $270,000 $90,000 PV of cost owning at 9% ($991,845) Cost of Leasing: Lease payment (240,000) (240,000) (240,000) Purchase price option Net cash flow $198,000 $270,000 $90,000 PV cost of leasing @9% ($954,639)

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