High electricity costs have made Farmer Corporation’s chicken-plucking machine e

Question

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 $66,000 for five years, due at the beginning of each year. This machine will save Farmer $16,000 per year through reductions in electricity costs. As an alternative, Farmer can purchase a more energy-efficient machine from Basic Machine Corporation (BMC) for $335,000. This machine will save $26,000 per year in electricity costs. A local bank has offered to finance the machine with a $335,000 loan. The interest rate on the loan will be 8 percent on the remaining balance and will require five annual principal payments of $67,000. Farmer has a target debt-to-asset ratio of 62 percent. Farmer is in the 30 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 Net Advantage to leasing (NAL) in $?

b. How much debt is displaced by the lease? PV = _______

Explanation / Answer

NET ADVANTAGE TO LEASING - NAL The total monetary savings that would result from a person or a business choosing to lease an asset, as opposed to purchase it outright NAL is expressed as the money that would be saved by leasing an asset instead of buying it, not taking into account the cost of capital. Purchase Cost Year 1 Year 2 Year 3 Year 4 Year 5 cost -88,440.00 -83080 -77720 -72360 -67000 constant Principle of 67000 +interest Savings 26000 26000 26000 26000 26000 Net cost -62,440.00 -57,080.00 -51,720.00 -46,360.00 -41,000.00 Total cost due to purchase -2,58,600.00 Lease Cost Year 1 Year 2 Year 3 Year 4 Year 5 Cost      -66,000.00      -66,000.00      -66,000.00      -66,000.00      -66,000.00 Post tax lease payment -46200 -46200 -46200 -46200 -46200 Savings        16,000.00        16,000.00        16,000.00        16,000.00        16,000.00 Net cost -30200 -30200 -30200 -30200 -30200 Total cost due to lease -1,51,000.00 NAL 1,07,600.00 Benefit due to lease instead of purchase Debt displacement The amount of debt capacity taken up by a company's leasing activities. The more capital a company uses to lease assets, the lower the company's debt capacity will be, meaning that the company will not be able to borrow as much money After tax lease payment -46200 Forgone depreciation tax sheild -19800 SUM -66000 N 5 YEARS Yield 8% Interest on debt PV 285745.46 Debt displacement value PMT -66,000.00 FV 0

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