As part of its overall plant modernization and cost reduction program, Western F

Question

As part of its overall plant modernization and cost reduction program, Western
Fabrics’s management 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 the project’s 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 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 Western’s marginal federal-plus-state tax rate
is 40%.
Aubey Automation Inc., maker of the loom, has offered to lease the loom to Western
for $70,000 upon delivery and installation (at t = 0) plus four additional annual lease
payments of $70,000 to be made at the end of Years 1 to 4. (Note that there are five lease
payments in total.) The lease agreement includes maintenance and servicing. 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. Western 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?
b. The salvage value is clearly the most uncertain cash flow in the analysis. What effect
would a salvage value risk adjustment have on the analysis? (Assume that the
appropriate salvage value pre-tax discount rate is 15%.)
c. Assuming that the after-tax cost of debt should be used to discount all anticipated
cash flows, at what lease payment would the firm be indifferent to either leasing or
buying?

Explanation / Answer

Part - A

The Cash flows for purchasing and leasing is as shown bleow:

Looking at the cash flows : we can see that Leasing is better

Hence Leasing is a better option

Part -B

Even if the salavge vage is significantly different, there is no major impact in the cash flows and still leasing would be better

Part -C

Now if we want to make the cash flows in both options indifferent, The lease payment should be $166,000 as shown below. Then the cash flows become same and the compnay can choose any of the two otions

For Purchase Year 0 1 2 3 4 Cost -250000 Profits(Assumed) 500000 500000 500000 500000 Less: Interest Payment on Loan 78867.7 78867.7 78867.7 78867.7 Less: Service Cost 20000 20000 20000 20000 Less: Dpericiation using double declining for 8 years 62500 46875 35156 26367 Total Cash Flow 338632.3 354257.3 365976.3 374765.3 Salavge Value 0 0 0 42500 Total Cash Flow 338632.3 354257.3 365976.3 417265.3 Tax @ 40% 135452.9 141702.9 146390.5 166906.1 Total cash flow -250000 203179.4 212554.4 219585.8 250359.2 Leasing Year 0 1 2 3 4 Initial Inv -70000 Profits( Assumed) 500000 500000 500000 500000 Less: Lease 70000 70000 70000 70000 Total Cash Flow 430000 430000 430000 430000 tax 172000 172000 172000 172000 Total Cash FLow -70000 258000 258000 258000 258000

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