Maintenance fee $20,000
Tax Rate 40%
Equipment expected life 8
Expected salvage value $0
Market value after 4 years $42,500
Book value after 4 years $42,500
Ending loan balance $196,132 $136,878 $71,698 $0
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A B C D E F G H I J
Solution 12/8/2012
Chapter: 19
Problem: 6
a. Should the loom be leased or purchased?
First, we want to lay out all of the input data in the problem.
INPUT DATA
Invoice Price $250,000
Length of loan 4
Loan Interest rate 10%
First, we can determine the annual loan payment that must be made on the new equipment. We will do so using the
function wizard for PMT.
Annual loan payment = $78,868
Year 1 2 3 4
As part of its overall plant modernization and cost reduction program, Western Fabrics’ management has decided to
install a new automated weaving loom. In the capital budgeting analysis of this equipment, the IRR of the project was
found to be 20% versus the project’s required return of 12%.
Gardial Automation Inc., maker of the loom, has offered to lease the loom to Westen for $70,000 upon delivery and
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 that there are 5 lease payments in total.) The lease agreement includes maintenance and servicing. Actually, the
loom has an expected life of eight years, at which time its expected salvage value is zero; however, after 4 years, its
market value is 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 interest in either leasing or owning the proposed loom for more than that period.
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Loan proceeds $250,000
After-tax interest payment ($15,000) ($11,768) ($8,213) ($4,302)
Principal payment ($53,868) ($59,254) ($65,180) ($71,698)
Maintenance cost ($20,000) ($20,000) ($20,000) ($20,000)
Tax savings from depreciation $20,000 $32,000 $19,200 $11,520
Salvage value $42,500
Net cash flow from ownership $0 ($60,868) ($51,022) ($66,193) ($33,980)
PV cost of ownership ($185,324)
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Tax savings from lease payment $28,000 $28,000 $28,000 $28,000 $28,000
Net cash flow from leasing ($42,000) ($42,000) ($42,000) ($42,000) ($42,000)
PV cost of leasing ($187,534)
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Our NPV Analysis has told us that there is a negative advantage to leasing. We interpret that as an indication that the
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 J
MACRS 5-year Depreciation Schedule
Year 1 2 3 4 5 6
NPV LEASE ANALYSIS OF INCREMENTAL CASH FLOWS
Year = 0 1 2 3 4
Cost of ownership
Purchase cost ($250,000)
Cost of leasing
Lease payment ($70,000) ($70,000) ($70,000) ($70,000) ($70,000)
Cost Comparison
PV ownership cost @ 6% ($185,324)
PV of leasing @ 6% ($187,534)
Net Advantage to Leasing ($2,211)
Before proceeding with our NPV analysis we must determine the schedule of depreciation charges for this new
equipment.
We can now construct our table of incremental cash flows from these two alternatives. Remember, that the
appropriate discount rate in this scenario is the after tax cost of borrowing, or: 10%*(1-40%) = 6%.
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PV ownership cost @ 6% ($188,880)
PV of leasing @ 6% ($187,534)
Net Advantage to Leasing $1,345
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Crossover = $69,175
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All cash flows would remain unchanged except that of the salvage value. Our new array of cash flows would resemble the
following:
Year = 0 1 2 3 4 4
Net cash flow $0 ($60,868) ($51,022) ($66,193) ($76,480) $42,500
PV of net cash flows $0 ($57,422) ($45,410) ($55,577) ($60,579) $30,108
NPV of ownership ($188,880)
We will use the Goal Seek function to determine the lease payment that makes the Net Advantage to Leasing zero.
Under this new assumption of using a greater discount factor for the salvage value, we find that the firm should lease,
and not buy, the equipment.
c. Assuming that the after-tax cost of debt should be used to discount all anticipated cash flows, at what lease
payment would the firm be indifferent to either leasing or buying?
b. The salvage value is clearly the most uncertain cash flow in the analysis. Assume that the appropriate salvage
value pre-tax discount rate is 15 percent. What would be the effect of a salvage value risk adjustment on the
decision?
Standard discount rate 10%
Salvage value rate 15%