Question

Sadik Industries must install $1 million of new machinery in its Texas plant. It can obtain a 6-year bank loan for 100% of the cost at a 14% interest rate with equal payments at the end of each year. Sadik’s tax rate is 40%. The equipment falls in the MACRS 3-year class.

Year	3-year MACRS
1	33.33%
2	44.45%
3	14.81%
4	7.41%

Alternatively, a Texas investment banking firm that represents a group of investors can arrange a guideline lease calling for payments of $320,000 at the end of each year for 3 years. Under the proposed lease terms, the Sadik must pay for insurance, property taxes, and maintenance.

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 Year 3. The best estimate of this market value is $210,000, but it could be much higher or lower under certain circumstances. If purchased at Year 3, the used equipment would fall into the MACRS 3-year class. Sadik would actually be able to make the purchase on the last day of the year (i.e., slightly before Year 3), so Sadik would get to take the first depreciation expense at Year 3 (the remaining depreciation expenses would be from Year 4 through Year 6). On the time line, Sadik would show the cost of purchasing the used equipment at Year 3 and its depreciation expenses starting at Year 3.

To assist management in making the proper lease-versus-buy decision, you are asked to answer the following questions:

What is the net advantage of leasing? Should Sadik take the lease? (Round your answer to the nearest dollar.) Explain.
Net advantage to leasing   $
Since the cost of leasing the machinery is -Select-lessgreaterItem 2 than the cost of owning it, the firm should -Select-leasebuyItem 3 the equipment.

Consider the $210,000 estimated residual value. How high could the residual value get before the net advantage of leasing falls to zero? (Round your answer to the nearest dollar.)
  $

Answer 1

Depreciation Schedule of New Equipment
Year	3-year MACRS	Depreciation $1,000,000 x Dep.Rate	Book Value
0			$1,000,000.00
1	33.33%	$333,300.00	$666,700.00
2	44.45%	$444,500.00	$222,200.00
3	14.81%	$148,100.00	$74,100.00
4	7.41%	$74,100.00	$0.00
Amortization Schedule of Loan
Principal	$1,000,000.00
Rate	14.00%
Period	6
Annual Payment	$257,157.50
Year	Loan payment	Interest = $1million x 14%	Principal	Ending Loan Balance
0				$1,000,000.00
1	$257,157.50	$140,000.00	$117,157.50	$882,842.50
2	$257,157.50	$123,597.95	$133,559.55	$749,282.96
3	$257,157.50	$104,899.61	$152,257.88	$597,025.08
4	$257,157.50	$83,583.51	$173,573.98	$423,451.09
5	$257,157.50	$59,283.15	$197,874.34	$225,576.75
6	$257,157.50	$31,580.75	$225,576.75	-$0.00
Discount rate = 14% x (1 - T) = 14% x (1 - 0.40) =	8.40%
Cost of Owning
Year	0	1	2	3	4	5	6
Loan payments		-$257,157.50	-$257,157.50	-$257,157.50	-$257,157.50	-$257,157.50	-$257,157.50
Interest tax savings @40%		$56,000.00	$49,439.18	$41,959.85	$33,433.40	$23,713.26	$12,632.30
Depreciation Tax savings @ 40%		$133,320.00	$177,800.00	$59,240.00	$29,640.00	$0.00	$0.00
Purchase of equipment	-$1,000,000.00
Loan proceeds	$1,000,000.00
Net cash flow	$0.00	-$67,837.50	-$29,918.32	-$155,957.65	-$194,084.09	-$233,444.23	-$244,525.20
PV @ 8.40%	$1.0000	$0.9225	$0.8510	$0.7851	$0.7242	$0.6681	$0.6163
Present Value	$0.00	-$62,580.72	-$25,461.18	-$122,438.74	-$140,563.58	-$155,968.44	-$150,712.03
NPV	-$657,724.69
Depreciation Schedule of Used Equipment
Year	3-year MACRS	Depreciation $1,000,000 x Dep.Rate	Book Value
0
1
2			$210,000.00
3	33.33%	$69,993.00	$140,007.00
4	44.45%	$93,345.00	$46,662.00
5	14.81%	$31,101.00	$15,561.00
6	7.41%	$15,561.00	$0.00
Cost of Leasing
Year	0	1	2	3	4	5	6
After-tax lease payment		-$192,000.00	-$192,000.00	-$192,000.00
Market value of machine				-$210,000.00
Depreciation tax savings				-$27,997.20	-$37,338.00	-$12,440.40	-$6,224.40
Net cash flow	0	-$192,000.00	-$192,000.00	-$429,997.20	-$37,338.00	-$12,440.40	-$6,224.40
PV @ 8.40%	$1.0000	$0.9225	$0.8510	$0.7851	$0.7242	$0.6681	$0.6163
Present Value	$0.00	-$177,121.77	-$163,396.47	-$337,580.83	-$27,041.70	-$8,311.66	-$3,836.38
NPV	-$717,288.81
Net advantage to leasing = -$657,724.69 - (-$717,288.81)	$59,564.12
b)
Since the cost of leasing of the machinery is lessor than the cost of owning it, the firm should lease the equipment.
c)
Cost of Leasing
Year	0	1	2	3	4	5	6
After-tax lease payment		-$192,000.00	-$192,000.00	-$192,000.00
Market value of machine				-$210,000.00
Depreciation tax savings				-$27,997.20	-$37,338.00	-$12,440.40	-$6,224.40
After Tax Residual value = $210,000 - ($210,000 - $74100)*40%)							$155,640.00
Net cash flow	0	-$192,000.00	-$192,000.00	-$429,997.20	-$37,338.00	-$12,440.40	$149,415.60
PV @ 8.40%	$1.0000	$0.9225	$0.8510	$0.7851	$0.7242	$0.6681	$0.6163
Present Value	$0.00	-$177,121.77	-$163,396.47	-$337,580.83	-$27,041.70	-$8,311.66	$92,091.65
NPV	-$621,360.78
Net advantage to leasing = -$657,724.69 - (-$621,360.78)	-$36,363.91