You are considering the purchase of a new zippy fabricating machine for your fir

Question

You are considering the purchase of a new zippy fabricating machine for your firm, Cherry Enterprises, Inc. CEI makes novelty items for wholesale to retail outlets located in tourist traps. The purchase of the zippy will allow CEI to market a new product, a walking stick with built-in bear repellant. In order to analyze the decisions to manufacture and sell the walking sticks and to lease the zippy, you have collected the following data, some of which may be relevant (all dollars in 2017 prices):

Cost of zippy = $10,000,000

Useful (and depreciable) life of zippy = 10 years

Salvage value (market and depreciation) of zippy = $0

Expected walking stick sales volume (in lots of 1000) = 2500/year

Wholesale price per 1000 lot of walking sticks = $1099

Annual zippy maintenance contract costs = $100,000 (the only cash fixed cost)

Average variable cost per lot of walking sticks = $550

Additional working capital (supplies inventory) required at beginning of year 1 = $200,000

Current equity = $50,000,000

Current debt = $50,000,000

Marginal tax rate for CEI = 30%

Inflation rate = .03

Zippy can be financed in several ways. The following data pertain to financing options:

Required return on equity (real) = .05

Bank loan interest rate available, given current capital structure = .06

Lease contract with payments made in 10 equal annual installments, beginning at start of

lease period. Lease contract includes maintenance costs. Payment = $1,250,000

Evaluate the zippy as a business opportunity for CEI. Evaluate the lease financing option for the zippy as well. Use the “easy way” to value a financial lease that is presented in BMA Chapter 25. Although CEI is a tax-paying entity and could benefit from the use of MACRS depreciation, for simplicity here (i.e., my grading ease), please use straight-line depreciation expense recognition.

Learning Points:

1.Investment decision analysis (again)

2.Lease financing analysis

3.Discount rate for lease analysis v. discount rate for investment analysis

4.Separation of investment and financing analyses

5.Real v. nominal interest rates and prices (again)

Explanation / Answer

Soln : We have to first calculate the discount rate , which is WACC = wd* cost of debt + we * cost of equity

WACC = 0.5*6*0.7% +0.5*0.05% = 4.6%% as cost of debt to be taken after tax

Now, please refer the table for the cash flows for purchasing :

For leaseing:

As per the above data and NPV, leasing is better option in this model.

Year 0 1 2 3 4 5 6 7 8 9 10 Revenue(R) 2747500 2747500 2747500 2747500 2747500 2747500 2747500 2747500 2747500 2747500 Fixed cost(F) 100000 100000 100000 100000 100000 100000 100000 100000 100000 100000 Variable cost(V) 1375000 1375000 1375000 1375000 1375000 1375000 1375000 1375000 1375000 1375000 Working capital cost 200000 Depreciation(D) 1000000 1000000 1000000 1000000 1000000 1000000 1000000 1000000 1000000 1000000 Total cash flows(C=R-P-V-F-D) -200000 272500 272500 272500 272500 272500 272500 272500 272500 272500 272500 Cash flow after tax (C*(1-0.3) 190750 190750 190750 190750 190750 190750 190750 190750 190750 190750 Add back Depreciation 1000000 1000000 1000000 1000000 1000000 1000000 1000000 1000000 1000000 1000000 Net cash flows(c) 1190750 1190750 1190750 1190750 1190750 1190750 1190750 1190750 1190750 1190750 Initial outlay -10000000 PV (c/1.046^t) 1138384 1088321.531 1040460 994704 950959.8 909139.407 869158 830935.1 794393 759458 Total NPV(sum) -824086.3

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