Question

DogChew Products needs to replace its rawhide tanning and molding equipment. They have undergone a capital budgeting NPV analysis and have determined they should accept the project. You have been provided with the following information

The equipment has a purchase price of $930,000 and has a seven-year useful life.

The estimated salvage value is $95,000 in seven years.

If they lease the equipment from RayNot Financing, the lease payments will be $205,000 per year for 7 years with the payments made at the beginning of the year.

If the asset is purchased, Dog Chew Products will be responsible for maintenance costs of $55,000 per year; if leased, the lessee will be responsible for maintenance costs. Maintenance costs are paid at the end of the year.

If the asset is leased, additional insurance of $10,000 per year will be required which the lessee is responsible for. This must be paid at the beginning of each year.

The asset belongs in an asset class with a CCA rate of 20%.

Dog Chew Products has a marginal tax rate of 35%. The before-tax cost of debt is 9%. The lease qualifies as a true tax lease for tax purposes.

Should Dog Chew Products buy or lease the equipment? Prepare a NPV _Lease analysis.

How would your answer to part (a) change if the lessor was responsible for the annual maintenance costs? Show your work.

Answer 1

		ANALYSIS OF BUY OPTION:
		Present Value (PV) of Cash Flow:
		(Cash Flow)/((1+i)^N)
		i=Discount Rate=9*(1-0.35)=5.85%= 0.0585
		N=Year of Cash Flow
	N	Year	0	1	2	3	4	5	6	7
	A	Initial cash flow(Purchase Price)	($930,000)
	B	Maintenance		($55,000)	($55,000)	($55,000)	($55,000)	($55,000)	($55,000)	($55,000)
	C	Beginning bookValue		$930,000	$744,000	$595,200	$476,160	$380,928	$304,742	$243,794
	D=C*0.2	Annual Depreciation		$186,000	$148,800	$119,040	$95,232	$76,186	$60,948	$48,759
	E=C-D	Ending Book value		$744,000	$595,200	$476,160	$380,928	$304,742	$243,794	$195,035
	F=D*0.35	Cash flow due to Depreciation tax shield		$65,100	$52,080	$41,664	$33,331	$26,665	$21,332	$17,066
	G=A+B+F	Net Cash Flow	($930,000)	$10,100	($2,920)	($13,336)	($21,669)	($28,335)	($33,668)	($37,934)
	H	TerminalCash Flow (Salvage value)								$95,000
	I=0.35*(195035-95000)	Tax Savings due to loss on salvage								$35,012
	J =G+H+I	Total Cash Flow	($930,000)	$10,100	($2,920)	($13,336)	($21,669)	($28,335)	($33,668)	$92,078	SUM
	PV=J/(1.0585^N)	Present Value (PV)of cash flow	$       (930,000)	$        9,542	$       (2,606)	$   (11,245)	$    (17,261)	$     (21,324)	$     (23,937)	$                 61,847	$     (934,985)
		Present Worth of total costs	$       (934,985)
		ANALYSIS OF LEASE OPTION:
	N	Year	0	1	2	3	4	5	6	7
	A	Lease Payments	($205,000)	($205,000)	($205,000)	($205,000)	($205,000)	($205,000)	($205,000)
	B	Insurance Cost	($10,000)	($10,000)	($10,000)	($10,000)	($10,000)	($10,000)	($10,000)
	C=A+B	Total Cash flow	($215,000)	($215,000)	($215,000)	($215,000)	($215,000)	($215,000)	($215,000)	SUM
	PV=C/(1.0585^N)	Present Value (PV)of cash flow	$       (215,000)	$ (203,118)	$ (191,892)	$ (181,287)	$ (171,268)	$   (161,802)	$ (152,860)	$         (1,277,226)
		Present Worth of total costs	$    (1,277,226)
		DOG CHEW PRODUCT SHOULD BUY THE EQUIPMENT
		For buying option, Present worth of cost is lower