Question

Lease analysis As part of its overall plant modernization and cost reduction program, the management of Tanner-Woods Textile Mills has decided to install a new automated weaving loom. In the capital budgeting analysis of this equipment, the IRR of the project was 25% versus a project required return of 11%. The loom has an invoice price of $260,000, including delivery and installation charges. The funds needed could be borrowed from the bank through a 4-year amortized loan at a 9% interest rate, with payments to be made at year-end. In the event the loom is purchased, the manufacturer will contract to maintain and service it for a fee of $19,000 per year paid at year-end. The loom falls in the MACRS 5-year class, and Tanner-Woods's marginal federal-plus-state tax rate is 40%. The applicable MACRS rates are 19%, 33%, 18%, 15%, 10%, and 5%. United Automation Inc., maker of the loom, has offered to lease the loom to Tanner-Woods for $70,000 upon delivery and installation (at t = 0) plus 4 additional annual lease payments of $70,000 to be made at the end of Years 1 through 4. (Note that there are 5 lease payments in total.) The lease agreement includes maintenance servicing. Actually, the loom has an expected life of 10 years, at which time its expected salvage value is zero; however, after 4 years, its market value is expected to equal its book value of $42,500. Tanner-Woods plans to build an entirely new plant in 4 years, so it has no interest in leasing or owning the proposed loom for more than that period. Round your answers to the nearest dollar. Should the loom be leased or purchased? PV cost of owning at 5.4% is $ . PV cost of leasing at 5.4% is $ . Tanner-Woods Textile should the loom. The salvage value is clearly the most uncertain cash flow in the analysis. Assume that the appropriate salvage value pretax discount rate is 12%. What would be the effect of a salvage value risk adjustment on the decision? Round your answer to the nearest dollar. NPV is $ . The firm should the loom. The original analysis assumed that Tanner-Woods would not need the loom after 4 years. Now assume that the firm will continue to use the loom after the lease expires. Thus, if it leased, Tanner-Woods would have to buy the asset after 4 years at the then existing market value, which is assumed to equal the book value. What effect would this requirement have on the basic analysis? (No numerical analysis is required; just verbalize.) The firm would choose to as the net advantage. Explain. The input in the box below will not be graded, but may be reviewed and considered by your instructor. blank

Answer 1

Since there are many variables involved, as a first step, let's summarize the input data in a tabular form:

New Equipment cost		$ 260,000
New Equipment life		4
Equip. Residual Value		$ 42,500
Tax Rate		40%
Loan interest rate		9%
Annual rental charge		$ 70,000
After-tax cost of debt		5.4%
Maintenance if not leased		$ 19,000

Further let's roll out the depreciation schedule:

Depreciation schedule	Year =	0	1	2	3	4
Depreciation Rate			19.00%	33.00%	18.00%	15.00%
Depreciation Expense			49,400	85,800	46,800	39,000
Book Value at end of year			210,600	124,800	78,000	39,000

Please note: There are two discrepancies in the question:

1. MACRS depreciation schedule for 5 year asset class is not as given in the question. They are different. They are 20%, 32%, 19%, 12%, 12%, 5%. Any ways, we are sticking to what's given in the question.
2. Even if we go by the depreciation schedule given in the question, the book value at the end of year 4 is 39,000. While your question states that at the end of 4th year, the market value is same as book value of $ 42,500. This impacts our analysis because this will impact post tax salvage value.

Cost of Owning the asset: Please see the table below. Please see the linkage column that explains how each row has been calculated.

Figures in parenthesis mean negative values.

	Year =	0	1	2	3	4
Parameter	Linkage
Equipment cost		(260,000)
Loan amount	Full equipment cost as loan	260,000
Interest expense	Loan x Interest rate		(23,400)	(23,400)	(23,400)	(23,400)
Tax savings from interest	Tax rate x interest expense		9,360	9,360	9,360	9,360
Principal repayment						(260,000)
After tax loan payment			(14,040)	(14,040)	(14,040)	(274,040)
Depreciation shield	Depreciation x tax rate		19,760	34,320	18,720	15,600
Maintenance		(19,000)	(19,000)	(19,000)	(19,000)
Tax savings on maintenance	Maintenance x tax rate	7,600	7,600	7,600	7,600	-
Residual value						42,500
Tax on residual value	(Residual value - book value) x Tax rate					(1,400)
Net cash flow		(11,400)	(5,680)	8,880	(6,720)	(217,340)
PV factor	(1 + 5.4%)-Year number	1.0000	0.9488	0.9002	0.8540	0.8103
PV of cash flows	Net cash flow x PV factor	(11,400.0)	(5,389.0)	7,993.4	(5,739.1)	(176,107.2)
PV of owning the asset @ 5.4%		($190,642)

Let's now look at the PV of leasing the asset:

Please see the table below. Please see the linkage column.

	Year =	0	1	2	3	4
Parameter	Linkage
Lease payment		($70,000)	($70,000)	($70,000)	($70,000)	($70,000)
Tax savings from lease	Lease payment x Tax rate	$28,000	$28,000	$28,000	$28,000	$28,000
Net cash flow		($42,000)	($42,000)	($42,000)	($42,000)	($42,000)
PV factor	(1 + 5.4%)Year number	1.0000	0.9488	0.9002	0.8540	0.8103
PV of cash flows	Net cash flow x PV factor	(42,000)	(39,848)	(37,807)	(35,870)	(34,032)
PV of leasing @ 5.4%		($189,556)

The firm should lease the equipment as per analysis below:

Comparison	Linkage	Value
PV of leasing @ 6%	A	(189,556)
PV ownership cost @ 6%	B	(190,642)
Net Advantage to Leasing	A - B	1,086

What would be the effect of a salvage value risk adjustment on the decision? Round your answer to the nearest dollar.

The cash flows without salvage value should be discounted at 5.4% while salvage value should be discounted at 12%

To achieve this, let's subtract the PV of salavge value at 5.4% to the previously calculated NPV and add the PV of salvage value at 12%.

Hence, PV of owning the asset, revised = Earlier calculated PV of owning the asset - 42,500 / (1 + 5.4%)⁴ + 42,500 / (1 + 12%)⁴ = - $190,642 - 42,500 / (1 + 5.4%)⁴ + 42,500 / (1 + 12%)⁴ = - $198,070

The PV has become even more negative. Hence, the firm should lease the asset.

Now assume that the firm will continue to use the loom after the lease expires. Thus, if it leased, Tanner-Woods would have to buy the asset after 4 years at the then existing market value, which is assumed to equal the book value. What effect would this requirement have on the basic analysis? (No numerical analysis is required; just verbalize.) The firm would choose to as the net advantage. Explain.

In both the scenarios, the firm will incur an expenditure of $ 42,000 at the end of year 4. In lease scenario, this cash flow is required to buy the asset. In owned scenario, this outflow is required to negate the impact of salvage value considered in the cash flows. Thus NPVs may decrease in absolute values, the difference of them (Net benefit of Leasing) will continue to remain the same as it was before. Hence, it's still favorable for the firm to lease.