Question

Kumquat Farms Ltd. has decided to acquire a kumquat picking machine. The cost of the picking machine is $45,000, and it has an economic life of 10 years. At the end of seven years, the market (salvage) value is estimated to be $11,000. Seven years is the time horizon for analysis.

The owner of Kumquat Farms Ltd. has discussed this acquisition with his financial services conglomerate. It has agreed to lend him the purchase price at 10 percent per year, payable in equal blended payments at the end of each year, for seven years.

An alternative method of financing the equipment would be to lease it from the local leasing store. Annual lease payments, payable at the beginning of each of the next seven years, would be $7,750. This would be considered an operating lease.

The equipment has a CCA of 20 percent. The benefits of any tax shields are realized at the end of each year. The company’s tax rate is 25 percent. Kumquat Farms’ cost of capital is 16 percent.

a-1. Calculate PV cost of lease alternative. (Do not round intermediate calculations. Round the final answer to nearest whole dollar. Input the answer as positive value.)

PV cost           $

a-2. Calculate PV cost of borrowing/purchase alternative. (Do not round intermediate calculations. Round the final answer to nearest whole dollar. Input the answer as positive value.)

PV cost           $

b. Should Kumquat Farms Ltd. lease or buy the picking machine?

• Lease

• Borrow/Purshase

Answer 1

	a-2	PV OF COST OF BORROWING /PURCHASE OPTION
		Equipment Cost	$45,000
		CCA RATE	20%
		A	B	C=A*B	D=A-B	D=C*25%	E
			CCA	Amount of	Ending	Depreciation	Accumulated
	Year	Beginning of Year Book value	Rate	Depreciation	Book value	Tax Shield	Depreciation
	1	$45,000	20.00%	$9,000	$36,000	$2,250	$9,000
	2	$36,000	20.00%	$7,200	$28,800	$1,800	$16,200
	3	$28,800	20.00%	$5,760	$23,040	$1,440	$21,960
	4	$23,040	20.00%	$4,608	$18,432	$1,152	$26,568
	5	$18,432	20.00%	$3,686	$14,746	$922	$30,254
	6	$14,746	20.00%	$2,949	$11,796	$737	$33,204
	7	$11,796	20.00%	$2,359	$9,437	$590	$35,563
		Book Value at end of year 7=45000-35563	$9,437
		Salvage Value (Before Tax)	$11,000
		Gain on Salvage =11000-9437	$1,563
		Tax On Gain =1563*25%	$391
		After tax salvage Cash Flow=11000-391=	$10,609