Problem 21-18 Lease or Buy High electricity costs have made Farmer Corporation’s
ID: 2776332 • Letter: P
Question
Problem 21-18 Lease or Buy
High electricity costs have made Farmer Corporation’s chicken-plucking machine economically worthless. Only two machines are available to replace it. The International Plucking Machine (IPM) model is available only on a lease basis. The lease payments will be $77,000 for five years, due at the beginning of each year. This machine will save Farmer $27,000 per year through reductions in electricity costs. As an alternative, Farmer can purchase a more energy-efficient machine from Basic Machine Corporation (BMC) for $390,000. This machine will save $37,000 per year in electricity costs. A local bank has offered to finance the machine with a $390,000 loan. The interest rate on the loan will be 11 percent on the remaining balance and will require five annual principal payments of $78,000. Farmer has a target debt-to-asset ratio of 68 percent. Farmer is in the 40 percent tax bracket. After five years, both machines will be worthless. The machines will be depreciated on a straight-line basis.
a. What is the NAL of leasing? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))
NAL $
b. How much debt is displaced by this lease? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))
PV $
Explanation / Answer
Cash inflows from buying option
Annual depreciation = (cost of machine –salvage value)/ life
= (390,000-0)/5
= 78000
Depreciation tax benefit = tax rate x annual depreciation
= 40%x78000
= 31,200
OCF = Annual savings x (1- t) + Depreciation tax benefit
= 37000 x(1-0.40) + 31,200
= 53,400
Cash flows from leasing option
OCF from year 2-4
OCF = (annual saving – rental payment) x (1- t)
= (27000-77000) x (1-0.40)
= -30,000
OCF year 5
OCF = (annual savings) x (1- t)
= (27000) x (1-0.40)
= 16,200
Cost of capital
Interest rate =11%
Tax rate = 40%
Cost of capital =interest rate x ( 1- tax rate)
= 11% x (1-0.40)
= 6.60%
year
Buy
Lease
Advantage
PV factor 6.60%
PV
0
-390000
-77000
313000
1.0000
313000
1
53400
-30000
-83400
0.9381
-78236.4
2
53400
-30000
-83400
0.8800
-73392.5
3
53400
-30000
-83400
0.8255
-68848.5
4
53400
-30000
-83400
0.7744
-64585.8
5
53400
16200
-37200
0.7265
-27024.5
NAL
912.34
Hence, Net advantage of leasing is 912.34.
b) Since all the amount of cost of machine is being financed through debt and lease will remove this debt obligation. Hence, total debt displacement is 390,000.
year
Buy
Lease
Advantage
PV factor 6.60%
PV
0
-390000
-77000
313000
1.0000
313000
1
53400
-30000
-83400
0.9381
-78236.4
2
53400
-30000
-83400
0.8800
-73392.5
3
53400
-30000
-83400
0.8255
-68848.5
4
53400
-30000
-83400
0.7744
-64585.8
5
53400
16200
-37200
0.7265
-27024.5
NAL
912.34
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