Question

Morris-Meyer Mining Company must install $1.4 million of new machinery in its Nevada mine. It can obtain a bank loan for 100% of the required amount. Alternatively, a Nevada investment banking from that represents a group of investors believes that it can arrange for a lease financing plan. Assume that the following facts apply: The equipment falls in the MACRS 3-year class. The applicable MACRS rates are 33%, 45%, 15%, and 7%. Estimated maintenance expenses are $65,000 per year. Morris-Meyer's federal-plus-state tax rate is 45%. If the money is borrowed, the bank loan will be at a rate of 14%, amortized in 4 equal installments to be paid at the end of each year. The tentative lease terms call for end-of-year payments of $300,000 per year for 4 year. Under the proposed lease terms, the lessee must pay for insurance, property taxes, and maintenance. The equipment has an estimated salvage value of $300,000, which is the expected market value after 4 years, at which time Morris-Meyer plans to replace the equipment regardless of whether the firm leases or purchases it. The best estimate for the salvage value is $300,000, but it may be much higher or lower under certain circumstances. To assist management in marking the proper lease-versus-buy decision, you are asked to answer the following questions. Assuming that the lease can be arranged, should Morris-Meyer lease or borrow and buy the equipment? Explain. Round your answer to the whole number. Net advantage to leasing (NAL) is $ . (Input the minus sign if the cost of leasing the machinery is more than the cost of owning it.)

Answer 1

		Present Value of Cash Flow;
		(Cash Flow)/((1+i)^N)
		i=discount Rate=After taxcost of debt =14*(1-0.45)=7.7%		0.077
		N=Year of cash Flow
		ANALYSIS OF BORROW AND PURCHASE OPTION
		3 year MACRS -GDS
		Equipment Cost=$3,000,000	$1,400,000
			A	B=A*$1,400,000	C=B*45%
			Depreciation	Amount of	Depreciation
		Year	Rate	Depreciation	Tax Shield
		1	33%	$462,000	$207,900
		2	45%	$630,000	$283,500
		3	15%	$210,000	$94,500
		4	7%	$98,000	$44,100
		INTEREST AND PRINCIPAL REPAYMENT ON AMOUNT BORROWED
	Pv	Amount Borrowed	$1,400,000
	Nper	Number of years of repayment	4
	Rate	Interest Rate	14%
	PMT	Annual repayment for 4years	$480,487	(Using PMT function of excelwith Rate=14%,Nper=4, Pv=-1400000
		REPAYMENT SCHEDULE
		Year		1	2	3	4
	A	Beginning Balance		$1,400,000	$1,115,513	$791,198	$421,480
	B	Amount of annual payment		$480,487	$480,487	$480,487	$480,487
	C=A*14%	Interest		$196,000	$156,172	$110,768	$59,007
	D=B-C	Principal		$284,487	$324,315	$369,719	$421,480
	E=A-D	Ending Balance		$1,115,513	$791,198	$421,480	$0
		After tax Salvage Value =300000*(1-0.45)	$165,000
	N	Year	1	2	3	4
		Annual Cash Inflows:
	a	Annual Repayment	$480,487	$480,487	$480,487	$480,487
	b=65000*(1-0.45)	After tax maintenance expense	$35,750	$35,750	$35,750	$35,750
	c=C*45%	Interest Tax Shield	$88,200	$70,277	$49,846	$26,553
	d	Depreciation Tax Shield	$207,900	$283,500	$94,500	$44,100
	e=a+b-c-d	After tax Net Cash Out Flow	$220,137	$162,459	$371,891	$445,583
	f	Terminal cash inflow for salvage				$165,000
	CF=e-f	PROJECTED NET CASH OUTFLOW	$220,137	$162,459	$371,891	$280,583	SUM
	PV=CF/(1.077^N)	PRESENT VALUE OF NET CASH OUT FLOW	$204,398	$140,060	$297,693	$208,545	$850,696
	PW=Sumof PV	Present Worth of Cost	$850,696
		ANALYSIS OF LEASE OPTION
	N	Year	1	2	3	4
	a	Before tax Lease Expense	$300,000	$300,000	$300,000	$300,000
	b	Before tax Maintenance Expense	$65,000	$65,000	$65,000	$65,000
	c=a+b	Total before tax expenses	$365,000	$365,000	$365,000	$365,000
	b	After tax Expense(365000*(1-0.45)	$200,750	$200,750	$200,750	$200,750	SUM
	c=b/(1.077^N)	Present Value of Net Cash Outflow	$186,397	$173,071	$160,697	$149,208	$669,374
	PW=Sumof PV	Present Worth of Cost	$669,374
		NET ADVANTAGE OF LEASING	$181,322	(850696-669374)