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Lease vs Purchase, Capital Budgeting

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1) Lease vs. Purchase: The Hot Bagel Shop wishes to evaluate two plans, leasing and borrowing to purchase, for financing an oven. The firm is in the 40% tax bracket.

Lease. The shop can lease the oven under a 5-year lease requiring annual end-of-year of \$5000. All maintenance costs will be paid by the lessor, and insurance and other costs will be borne by the lessee. The lessee will exercise its option to purchase the asset for \$4000 at termination of the lease.

Purchase the oven costs \$20,000 and will have a 5-year life. It will be depreciated under MACRS using a 5-year recovery period. The total purchase price will be financed by a 5 year, 15% loan requiring equal annual end-of-year payments of \$5,967. The firm will pay \$1000 per year for a service contract that covers all maintenance costs; insurance and other costs will be borne by the firm. The firm plans to keep the equipment and use it beyond its 5-year recovery period.

a. For the leasing plan, calculate the following:
(1) The after-tax cash outflow each year.
(2) The present value of the cash out flows, using a 9% discount rate.

b. For the purchasing plan, calculate the following:
(1) The annual interest expense deductible for tax purposes for each of the 5 years.
(2) The after-tax cash outflow resulting from the purchase for each of the 5 years.
(3) The present value of the cash outflows, using a 9% discount rate.

c. Compare the present value of the cash outflow streams from each plan, and determine which would be preferable. Explain your answer.

2) Marking Norwich Tool's Lathe Investment Decision: Norwich Tool, a large machine shop, is considering replacing one of its lathes with either of two new lathes-lathe A or lathe B. Lathe A is a highly automated, computer-controlled lathe; lathe B is a less expensive lathe that uses standard technology. To analyze these alternatives, Mario Jackson, a financial analyst, prepared estimates of the initial investment and incremental (relevant) cash inflows associated with each lathe. These are shown in the following table.
Lathe A Lathe B
Initial Investment (II) \$660,000 \$360,000
Year (t) Cash inflows (CFt)
1 \$128,000 \$ 88,000
2 182,000 120,000
3 166,000 96,000
4 168,000 86,000
5 450,000 207,000

Note that Mario plans to analyze both lathes over a 5-year period. At the end of that time, the lathes would be sold, thus accounting for the large fifth-year cash inflows.
One of Mario's major dilemmas centered on the risk of the two lathes. He feels that although the two lathes have similar risk, lathe A has a much higher chance of breakdown and repair due to its sophisticated and not fully proven solid-state electronic technology. Because he 9is unable to effectively quantify this possibility, Mario decides to apply the firms, 13 percent cost of capital when analyzing the lathes. Norwich Tool requires all projects to have3 a maximum payback period of 4 years.

a. Use the payback period to assess the acceptability and relative ranking of each lathe.
b. Assuming equal risk, use the following sophisticated capital budgeting techniques to assess the acceptability and relative ranking of each lathe:
1) Net present value (NPV).
2) Internal rate of return (IRR).
c. Summarize the preferences indicated by the techniques used in a and b, and indicate which lathe you recommend, if either, if the firm has (1) unlimited funds or (2) capital rationing.
d. Repeat part b assuming that Mario decides that, due to its greater risk, lathe A's cash inflows should be evaluated by using a 15% cost of capital.
e. What effect, if any, does recognition of lathe A's greater risk in d have on your recommendation in c?

Solution Summary

Evaluates a Lease vs Purchase decision. Uses payback, NPV, IRR to evaluate an equipment purchase decision

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