Question
In: Finance
High electricity costs have made Farmer Corporation’s chicken-plucking machine economically worthless. Only two machines are available...
High electricity costs have made Farmer Corporation’s chicken-plucking machine economically worthless. Only two machines are available to replace it. The International Plucking Machine (IPM) model is available only on a lease basis. The lease payments will be $73,000 for five years, due at the beginning of each year. This machine will save Farmer $23,000 per year through reductions in electricity costs. As an alternative, Farmer can purchase a more energy-efficient machine from Basic Machine Corporation (BMC) for $370,000. This machine will save $33,000 per year in electricity costs. A local bank has offered to finance the machine with a $370,000 loan. The interest rate on the loan will be 12 percent on the remaining balance and will require five annual principal payments of $74,000. Farmer has a target debt-to-asset ratio of 64 percent. Farmer is in the 40 percent tax bracket. After five years, both machines will be worthless. The machines will be depreciated on a straight-line basis.
What is the NAL of leasing?
How much debt is displaced by this lease?
how do you work through this problem using excel? Can this also be done using a calculator?
Solutions
Expert Solution
| Option 1 (Lease option) | Yr 0 | Yr 1 | Yr 2 | Yr 3 | Yr 4 | Yr 5 | Total |
| Annual Payout (Lease) | $ 73,000.00 | $ 73,000.00 | $ 73,000.00 | $ 73,000.00 | $ 73,000.00 | $ - | $ 365,000.00 |
| Interest Payout | $ - | $ - | $ - | $ - | $ - | ||
| Electricity savings (end of year assumed) | $ (23,000.00) | $ (23,000.00) | $ (23,000.00) | $ (23,000.00) | $ (23,000.00) | ||
| Net outflow (Pre tax) | $ 73,000.00 | $ 50,000.00 | $ 50,000.00 | $ 50,000.00 | $ 50,000.00 | $ (23,000.00) | |
| Tax saved * | $ (20,000.00) | $ (20,000.00) | $ (20,000.00) | $ (20,000.00) | $ (20,000.00) | ||
| Net outflow (Post tax) | $ 73,000.00 | $ 30,000.00 | $ 30,000.00 | $ 30,000.00 | $ 30,000.00 | $ (43,000.00) | |
| Discount factor (12%) | 1 | 0.892857 | 0.797194 | 0.711780 | 0.635518 | 0.567427 | |
| Current Value of Future Cash outflow | $ 73,000.00 | $ 26,785.71 | $ 23,915.82 | $ 21,353.41 | $ 19,065.54 | $ (24,399.35) | $ 139,721.13 |
| * Tax calculation | Yr 0 | Yr 1 | Yr 2 | Yr 3 | Yr 4 | Yr 5 | Total |
| Annual Payout (Lease) (Note) | - | $ 73,000.00 | $ 73,000.00 | $ 73,000.00 | $ 73,000.00 | $ 73,000.00 | $ 365,000.00 |
| Electricity savings (end of year assumed) | - | $ (23,000.00) | $ (23,000.00) | $ (23,000.00) | $ (23,000.00) | $ (23,000.00) | |
| Total expense (Pre tax) | - | $ 50,000.00 | $ 50,000.00 | $ 50,000.00 | $ 50,000.00 | $ 50,000.00 | |
| Taxes saved @ 40% | - | $ 20,000.00 | $ 20,000.00 | $ 20,000.00 | $ 20,000.00 | $ 20,000.00 |
| Option 2 (Purchase/Loan option) | Yr 0 | Yr 1 | Yr 2 | Yr 3 | Yr 4 | Yr 5 | Total |
| Annual Payout (Principal repayment) | - | $ 74,000.00 | $ 74,000.00 | $ 74,000.00 | $ 74,000.00 | $ 74,000.00 | $ 370,000.00 |
| Interest Payout ** | $ 44,400.00 | $ 35,520.00 | $ 26,640.00 | $ 17,760.00 | $ 8,880.00 | ||
| Electricity savings (end of year assumed) | $ (33,000.00) | $ (33,000.00) | $ (33,000.00) | $ (33,000.00) | $ (33,000.00) | ||
| Net outflow (Pre tax) | - | $ 85,400.00 | $ 76,520.00 | $ 67,640.00 | $ 58,760.00 | $ 49,880.00 | |
| Tax saved @ 40% | $ (34,160.00) | $ (30,608.00) | $ (27,056.00) | $ (23,504.00) | $ (19,952.00) | ||
| Net outflow (Post tax) | - | $ 51,240.00 | $ 45,912.00 | $ 40,584.00 | $ 35,256.00 | $ 29,928.00 | |
| Discount factor (12%) | 1 | 0.892857 | 0.797194 | 0.711780 | 0.635518 | 0.567427 | |
| Current Value of Future Cash outflow | - | $ 45,750.00 | $ 36,600.77 | $ 28,886.89 | $ 22,405.83 | $ 16,981.95 | $ 150,625.43 |
|
** Interest calculation |
Yr 0 | Yr 1 | Yr 2 | Yr 3 | Yr 4 | Yr 5 | Total |
| Principal (Opening balance) | $370,000.00 | $370,000.00 | $296,000.00 | $222,000.00 | $148,000.00 | $ 74,000.00 | |
| Principal repaid | - | $ 74,000.00 | $ 74,000.00 | $ 74,000.00 | $ 74,000.00 | $ 74,000.00 | |
| Outstanding Principal (Closing balance) | $370,000.00 | $296,000.00 | $222,000.00 | $148,000.00 | $ 74,000.00 | $ - | |
| Interest @ 12% (on opening balance) | $ 44,400.00 | $ 35,520.00 | $ 26,640.00 | $ 17,760.00 | $ 8,880.00 | $ 133,200.00 |
Note
Taxes are paid for each accounting year and on the accrual basis of accounting . Therefore, the lease paid at the beginning of the year has been adjusted.
Outflow saved is treated as inflow. Hence electricity savings and tax savings are treated as inflows.
What is the NAL of leasing?
NAL of Leasing = Cost of Purchasing - Cost of Leasing = $ 150,625.43 - $ 139,721.13 = $ 10,904.31
How much debt is displaced by this lease?
With the lease option, the farmer has displaced a debt of $ 370,000.
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