orris-Meyer Mining Company must install $1.5 million of new machinery in its Nev
ID: 2726528 • Letter: O
Question
orris-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 from that represents a group of investors believes that it can arrange for a lease financing plan. Assume that the following facts apply:
The equipment falls in the MACRS 3-year class. The applicable MACRS rates are 33%, 43%, 11%, and 7%.
Estimated maintenance expenses are $65,000 per year.
Morris-Meyer's federal-plus-state tax rate is 40%.
If the money is borrowed, the bank loan will be at a rate of 12%, amortized in 4 equal installments to be paid at the end of each year.
The tentative lease terms call for end-of-year payments of $250,000 per year for 4 year.
Under the proposed lease terms, the lessee must pay for insurance, property taxes, and maintenance.
The equipment has an estimated salvage value of $250,000, which is the expected market value after 4 years, at which time Morris-Meyer plans to replace the equipment regardless of whether the firm leases or purchases it. The best estimate for the salvage value is $250,000, but it may be much higher or lower under certain circumstances.
To assist management in marking the proper lease-versus-buy decision, you are asked to answer the following questions.
Assuming that the lease can be arranged, should Morris-Meyer lease or borrow and buy the equipment? Explain. Round your answer to the whole number.
Net advantage to leasing (NAL) is--------- $ . (Input the minus sign if the cost of leasing the machinery is more than the cost of owning it.
B. Consider the $250,000 estimated salvage value. Is it appropriate to discount it at the same rate as the other cash flows? What about the other cash flows - are they all equally risky?
Explain.
Explanation / Answer
- Note that the maintenance expense is excluded from the analysis since Morris-Meyer will have to bear the cost whether it buys or leases the machinery. Since the cost of leasing the machinery is less than the cost of owning it, Morris-Meyer should lease the equipment.
So, Morris-Meyer should go for Lease.
B. We assume that Morris-Meyer will buy the equipment at the end of 4 years if the lease plan is used; hence the $250,000 is an added cost under leasing. We discounted it at 12 percent, but it is risky, so should we use a higher rate? If we do, leasing looks even better. However, it really makes more sense in this instance to use a lower rate so as to penalize the lease decision, because the residual value uncertainty increases the uncertainty of operations under the lease alternative. In general, for risk-averse decision makers, it makes intuitive sense to discount riskier future inflows at a higher rate, but risky future outflows at a lower rate. (Note that if Morris-Meyer did not plan to continue using the equipment, then the $250,000 salvage value (less taxes) should be a positive (inflow) value in the cost of owning analysis. In this case, it would be appropriate to use a higher discount rate.)
The cash flows for borrowing and leasing, except for the residual value cash flow, are relatively certain because they’re fixed by contract, and thus, are not very risky.
Year 1 Cost of Owning 0 1 2 3 4 Net Purchase Price $ (1,500,000) Depreciation Tax Savings * 198,000 258,000 66,000 42,000 Net Cash Flows (1,500,000) 198,000 258,000 66,000 42,000 PVF 1.0000 0.8929 0.7972 0.7118 0.6355 PV of cost of owning at 12% (1,500,000) 176,786 205,676 46,977 26,692 NPV (1,043,869)Related Questions
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