Gardial Automation: Should the loom be leased or purchased?

Extracted Content from Question Files:

A B C D E F G H I
1 7/3/2003
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Chapter 20. Ch 20-06 Build a Model
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6 As part of its overall plant modernization and cost reduction program, Western Fabrics' management has decided to
7 install a new automated weaving loom. In the capital budgeting analysis of this equipment, the IRR of the project was
8 found to be 20% versus a project required return of 12%.
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10 The loom has an invoice price of $250,000, including delivery and installation charges. The funds needed could be
11 borrowed from the bank through a 4-year amortized loan at a 10% interest rate, with payments to be made at the end of
12 each year. In the event that the loom is purchased, the manufacturer will contract to maintain and service it for a fee of
13 $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-
14 plus-state tax rate is 40%.
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Gardial Automation Inc., maker of the loom, has offered to lease the loom to Westen for $70,000 upon delivery and
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17 installation (at t=0) plus 4 additional annual lease payments of $70,000 to be made at the ends of Years 1 through 4. (Note
18 that there are 5 lease payments in total.) The lease agreement includes maintenance and servicing. Actually, the loom has
19 an expected life of eight years, at which time its expected salvage value is zero; however, after 4 years, its market value is
20 expected to equal its book value of $42,500. Tanner-Woods plans to build and entirely new plant in 4 years, so it has no
21 interest in either leasing or owning the proposed loom for more than that period.
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23 a. Should the loom be leased or purchased?
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25 First, we want to lay out all of the input data in the problem.
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27 INPUT DATA
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29 Invoice Price $250,000
30 Length of loan 4
31 Loan Interest rate 10%
32 Maintenance fee $20,000
33 Tax Rate 40%
34 Lease fee $70,000
35 Equipment expected life 8
36 Expected salvage value $0
37 Market value after 4 years $42,500
38 Book value after 4 years $42,500
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40 First, we can determine the annual loan payment that must be made on the new equipment. We will do so using the
41 function wizard for PMT.
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43 Annual loan payment =
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45 Year 1 2 3 4
46 Beginning loan balance
47 Interest payment
48 Principal payment
49 Ending loan balance
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A B C D E F G H I
53 Now, we see that the decision being made is whether to purchase the equipment at a net cost of $250,000 (with annual
54 payments of $78,868) or lease the equipment and make annual payments of $70,000. To make this decision, we must
55 analyze the incremental cash flows.
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A B C D E F G H I
57 Before proceeding with our NPV analysis we must determine the schedule of depreciation charges for this new
58 equipment.
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60 MACRS 5-year Depreciation Schedule
61 Year 1 2 3 4 5 6
62 Depr. Rate 20% 32% 19% 12% 11% 6%
63 Depr. Exp.
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65 We can now construct our table of incremental cash flows from these two alternatives. Remember, that the appropriate
66 discount rate in this scenario is the after tax cost of borrowing, or: 10%*(1-40%) = 6%.
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68 NPV LEASE ANALYSIS OF INCREMENTAL CASH FLOWS
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70 Year = 0 1 2 3 4
71 Cost of ownership
72 Purchase cost
73 Loan proceeds
74 After-tax interest payment
75 Principal payment
76 Maintenance cost
77 Tax savings from maintenance cost
78 Tax savings from depreciation
79 Salvage value
80 Net cash flow from ownership
81 PV cost of ownership
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83 Cost of leasing
84 Lease payment
85 Tax savings from lease payment
86 Net cash flow from leasing
87 PV cost of leasing
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Cost Comparison
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90 PV ownership cost @ 6%
91 PV of leasing @ 6%
92 Net Advantage to Leasing
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94 Our NPV Analysis has told us that there is a negative advantage to leasing. We interpret that as an indication that the
95 firm should forego the opportunity to lease and buy the new equipment.
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A B C D E F G H I
97 b. The salvage value is clearly the most uncertain cash flow in the analysis. Assume that the appropriate salvage value
98 pre-tax discount rate is 15 percent. What would be the effect of a salvage value risk adjustment on the decision?
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100 All cash flows would remain unchanged except that of the salvage value. Our new array of cash flows would resemble the
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103 Standard discount rate 10%
104 Salvage value rate 15%
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106 Year = 0 1 2 3 4 4
107 Net cash flow
108 PV of net cash flows
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110 NPV of ownership
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112 New Cost Comparison
113 PV ownership cost @ 6%
114 PV of leasing @ 6%
115 Net Advantage to Leasing
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117 Under this new assumption of using a greater discount factor for the salvage value, we find that the firm should lease, and
118 not buy, the equipment.
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120 c. Assuming that the after-tax cost of debt should be used to discount all anticipated cash flows, at what lease payment
121 would the firm be indifferent to either leasing or buying?
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123 We will use the Goal Seek function to determine the lease payment that makes the Net Advantage to Leasing zero.
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125 Crossover =
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