Question

Use the information here for the following 7 questions (7-13).

Warf Computers needs specialized equipment for production.

The company can buy the equipment from Clapton Acoustical Equipment for $5 million.

The equipment falls in the three-year MACRS depreciation class.
                                                              MACRS Depreciation Allowances
                                                                               Property Class
                                         Year               3-year           5-year           7-year
                                             1                33.33%         20.00%         14.29%
                                             2                44.44%         32.00%         24.49%
                                             3                14.82%         19.20%         17.49%
                                             4                   7.41%         11.52%         12.49%
                                             5                                       11.52%           8.93%
                                             6                                         5.76%           8.93%
                                             7                                                              8.93%
                                             8                                                              4.45%               
At the end of four years, market value of the equipment is expected to be $600,000.

Alternatively, the company can lease from Hendrix Leasing. Lease contract calls for four annual payments of $1.3 million due at the beginning of the year.

Security deposit of $300,000 will be returned when the lease expires.
Warf Computers can issue bonds with a yield of 11 percent and the company has a marginal tax rate of 35%.

What is the highest offer Birdie can make?

		$594,254,610
		$44,254,610
		$400,000,000
		$650,000,000

Answer 1

When company owns the Asset , Company will borrow $5million using bonds and have to pay annual interest and in the 4th year end it has to pay principal of $5million. thi is considered in the last year out flow. and the negative amounts indicates cash outflows.

It is worth noting that if the company borrows, company doesnot have cash outflow in year0, because it acquired from investors and gives to the supplier, so company doesnot have cash outflow.

The information about cost of issue is absent in question, so it is ignored.

The salvage value is considered as after tax i.e, $600,000 X 65%(after tax) = $390,000 seperately in year 4.

Year	Original cost	Depreciation Rate	Depreciation	Tax Saved @35% on Depreciation
1	5000000	33.33%	1666500	583275
2	5000000	44.44%	2222000	777700
3	5000000	14.82%	741000	259350
4	5000000	7.41%	370500	129675
Year	Interest on Bond	Tax Saved @35% on interest
0
1	550000	192500
2	550000	192500
3	550000	192500
4	550000	192500
Year	payment on Bond	Tax Saved on interest & Depreciation	Net Savings	PV Factor @7.15%	PV of cash flow
1	550000	775775	225775	0.9332711152589830	210709.286047597
2	550000	970200	420200	0.8709949745767460	365992.088317149
3	550000	451850	-98150	0.8128744513082090	-79783.627395901
4	5550000	322175	-5227825	0.7586322457379460	-3965996.620074980
4	After Tax Salvage Value		390000	0.7586322457379460	295866.575837799
			Net present value of owning the asset		-3173212.297268330

If the company goes to leasing, it has to pay security deposit of $300,000 at year0(now) and has to pay first year lease at year0(now). So total outflow at year0 is 1.6million. the tax savings will be received at the time of assessment. so the tax savings of lease rent paid at the begining of the year is considered at the year end.

Year	Cash flow	Tax saved on Lease rent	Net cash flow	PV Factor @7.15%	PV of cash flow
0	-1600000		-1600000	1.0000000000000000	-1600000
1	-1300000	455000	-845000	0.9332711152589830	-788614.0924
2	-1300000	455000	-845000	0.8709949745767460	-735990.7535
3	-1300000	455000	-845000	0.8128744513082090	-686878.9114
4	300000	455000	755000	0.8128744513082090	613720.2107
			Net present value of leasing the asset		-3197763.547

The refund of security deposit is considered as inflow in the 4th year end.

All options will create the present value out flows.

Since the present value out flow of owning the asset is less, company will go with Owning by issuing bond.

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Thank you,…