Question

As part of its overall plant modernization and cost reduction program, the management of Tanner-Woods Textile Mills has decided to install a new automated weaving loom. In the capital budgeting analysis of this equipment, the IRR of the project was 25% versus a project required return of 11%.

The loom has an invoice price of $270,000, including delivery and installation charges. The funds needed could be borrowed from the bank through a 4-year amortized loan at a 9% interest rate, with payments to be made at year-end. In the event the loom is purchased, the manufacturer will contract to maintain and service it for a fee of $19,000 per year paid at year-end. The loom falls in the MACRS 5-year class, and Tanner-Woods's marginal federal-plus-state tax rate is 35%. The applicable MACRS rates are 20%, 33%, 19%, 16%, 13%, and 5%.

United Automation Inc., maker of the loom, has offered to lease the loom to Tanner-Woods for $70,000 upon delivery and installation (at t = 0) plus 4 additional annual lease payments of $70,000 to be made at the end of Years 1 through 4. (Note that there are 5 lease payments in total.) The lease agreement includes maintenance servicing. Actually, the loom has an expected life of 10 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 $46,000. Tanner-Woods plans to build an entirely new plant in 4 years, so it has no interest in leasing or owning the proposed loom for more than that period. Round your answers to the nearest dollar.

1. Should the loom be leased or purchased?

   PV cost of owning at 5.85% is $ .

   PV cost of leasing at 5.85% is $ .

   Tanner-Woods Textile should -Select-purchaseleaseItem 3 the loom.

2. The salvage value is clearly the most uncertain cash flow in the analysis. Assume that the appropriate salvage value pretax discount rate is 14%. What would be the effect of a salvage value risk adjustment on the decision? Round your answer to the nearest dollar.

   NPV is $ .

   The firm should -Select-purchaseleaseItem 5 the loom.

3. The original analysis assumed that Tanner-Woods would not need the loom after 4 years. Now assume that the firm will continue to use the loom after the lease expires. Thus, if it leased, Tanner-Woods would have to buy the asset after 4 years at the then existing market value, which is assumed to equal the book value. What effect would this requirement have on the basic analysis? (No numerical analysis is required; just verbalize.)

   The firm would choose to -Select-own or lease Item 6 as the net advantage.

   Explain.

Answer 1

a)Pv of cost of owing at 5.58% is $363,180.

Loan amount =$270, 000

Interest after 35% of tax = $15,795

Again interest for 4 years =$15,795*4=$63180.

total loan amount =$333, 180 now we also add maintenance cost in this ie $76000($19000*4)

which will give us a total of $409,180

Again as stated there is a salvage value of $46,000 which we will subtract = $409,180-$46,000=$363,180.

b)Pv of cost of leasing at 5.58% is $252,000.

Initial payment of $70,000

Again 4 year lease rent of $70000 calculated after tax = $182000 (70000*4*.65)

and we will add the two $70,000+$182000=$252,000.

c)If tanner woods textile opt to purchase 3 looms then,

NPV will be $711,785.96 , if we consider salvage value and discounting rate to be 14%

and if we will not take salvage value the our NPV will be $573,785.96

As irr of this project is 25% which when discounted at rate of 14% will give us $600,441.99 when then we will multiply by 3 as we have purchases 3 looms and the will be subtracted with the cost of 3 looms.

d)If the firm need 5 looms the best option is to lease the loom because the NPV will be more but then if they proceed with further use of loom then first they should lease and they should purchase the loom at market price of $46000. as at that time they will be charged less cost and more over they will have enough cash to purchase the loom with out any borrowing