Question

C.T. All Ltd., a manufacturer of customized baseball souvenirs, is negotiating with the Grand Slam Company to purchase or to lease a machine that produces foam cushions for seating at baseball parks. The machine would cost $250,000. In five years the machine would have an estimated salvage value of $40,000. Its useful economic life is nine years. These machines have a CCA rate of 20 percent.

C.T. All can borrow funds at 13 1/3 percent from its Nearby Bank, and has a tax rate of 25 percent. The capital cost rate on this machine is 9 percent, and C.T. All’s cost of capital is 15 percent. Lease payments would be at the beginning of each year, and tax savings would occur at the end of each year. Lease payments would be $64,645.

We note that of all the cash flows, the salvage value has the greatest uncertainty. We recognize this by discounting the salvage value at a higher discount rate—the cost of capital.

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

PV cost           $

b. Should C.T. All Ltd. lease or borrow to purchase the machine?

• Lease

• Borrow/Purchase

Answer 1

Answer:

a-1)  Calculation of  PV cost of lease alternative:

Particulars	Initial Year	Year 1	Year 2	Year 3	Year 4	Year 5
Lease Payment	$ 64,645 (Given)	$ 64,645	$ 64,645	$ 64,645	$ 64,645
(-) Tax Shield @ 25%	-	($ 16,161)	($ 16,161)	($ 16,161)	($ 16,161)	($ 16,161)
Net cash Flows	$ 64,645	$ 48,484	$ 48,484	$ 48,484	$ 48,484	($ 16,161)
PV factor @ 15%	1	0.9174	0.8417	0.7722	0.7084	0.6499
Present Values	$ 64,645	$ 44,481	$ 40,808	$ 37,438	$ 34,347	($ 10,504)

Present value of all cash flows = $ 64,645 + $ 44,481 + $ 40,808 + $ 37,438 + $ 34,347 - $ 10,504 = $ 211,215

Formula = Annual cost = Total Net cash flow / Present value annuity factor (Cummulative)

= $211,215 / 3.8897 = $ 54,301.10

a-2) Calculatin of  PV cost of borrowing/purchase alternative:

Particulars	Initial Year	Year 1	Year 2	Year 3	Year 4	Year 5
Machine cost	$ 250,000	-	-	-	-	-
Depreciation (CCA @ 20%)	-	($ 250,000 x 20%) = $ 50,000	{($250,000 - $ 50,000) x 20%}= $ 40,000	(Same as before calculation) $ 32,000	$ 25,600	$ 20,480
Interest @ 13 1/3% or 13.333%	-	$ 33,333	$ 33,333	$ 33,333	$ 33,333	$ 33,333
(-) Tax shield @ 25%	-	($ 20,833)	($ 18,333)	($ 16,333)	($ 14,733)	($ 13,45+3)
Net cash flows	$ 250,000	$ 12,499	$ 14,999	$ 16,999	$ 18,599	$ 19,879
PV factor @ 9%	1	0.9174	0.8417	0.7722	0.7084	0.6499
Present Values	$ 250,000	$ 11,467	$ 12,625	$ 13,127	$ 13,176	$ 12,920

Present value of all cash flows = $ 250,000 + $ 11,467 + $ 12,625 + $ 13,127 + $ 13,176 + $ 12,920 = $ 313,315

Formula = Annual cost = Total Net cash flow / Present value annuity factor (Cummulative)

= $ 313,315 / 3.8897 = $ 80,549.91

b) Should C.T. All Ltd. lease or borrow to purchase the machine?

Yes, as the annual costs associated with the lease or borrow option ($ 54,301.10) are lower than the other option ($ 80,549.91) , It is suggested to go for the lease or borrow option.

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