Depreciating Equipment
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A. Sadik Industries must install $1 million of new machinery in its Texas plant. It can obtain a bank loan for 100% of the required amount. Alternately, a Texas investment banking firm which represents a group of investors believes that it can arrange for a lease financing plan. Assume that these facts apply:
1) The equipment falls in the MACRS 3-year class.
2) Estimated maintenance expenses are $50,000 per year.
3) The firm's tax rate is 34%.
4) If the money is borrowed, the bank loan will be at a rate of 14%, amortized in
3 equal installments at the end of each year.
5) The tentative lease terms call for payments of $320,000 at the end of each
year for 3 years. The lease is a guideline lease.
6) Under the proposed lease terms, the lessee must pay for insurance, property
taxes, and maintenance.
7) Sadik must use the equipment if it is to continue in business, so it will almost certainly want to acquire the property at the end of the lease. If it does, then under the lease terms it can purchase the machinery at its fair market value at that time. The best estimate of this market value is $200,000, but it could be much higher or lower under certain circumstances.
To assist management in making the proper lease-versus-buy decision, you are asked to answer the following questions:
a. Assuming that the lease can be arranged, should the firm lease or borrow and buy the equipment? (Hint: In this situation, the firm plans to use the asset beyond the term of the lease. Thus, the residual value becomes a cost to leasing in Year 3. Also, there is no Year 3 residual value tax consequence, as the firm cannot immediately deduct the Tear 3 purchase price from taxable income).
b. Consider the $200,000 estimated residual value. Is it appropriate to discount it at the same rate as the other cash flows? What about the other cash flows - are they all equally risky? (Hint: Riskier cash flows are normally discounted at higher rates, but when the cash flows are costs rather than inflows, the normal procedure must be reversed).
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