Question

Project 4: Buy or Lease

Project description

Becky’s company is considering an investment project. To start, Becky just needs to purchase an equipment priced at $5,000. The equipment will follow a straight-line depreciation over 10 years. Each year’s depreciation is $500. The project will last 3 years. If Becky purchases the equipment for the project, the expected EBIT is $1000 each year in year 1-3. At the end of the year 3, the expected after-tax salvage value of the equipment is $4,200. The tax rate is 20%.

Becky can also lease the same equipment for year 1-3 and the annual leasing cost is $600 paid at the end of each year.

Becky’s company has an optimal capital structure of 50% debt. Its cost of equity is 10% and before-tax cost of debt is 6%.

Is the project worth doing? If yes, should Becky buy or lease the equipment?

Requirements

1. Present the case solution in an Excel file with clear labels, functions and descriptions.

2. Starting with the data provided, show each step of your work that leads to the conclusion.

3. Due in D2L by 11:59PM Sunday June 14.

Hints

1. You may need the following equations:

FCF=EBIT×(1-T)+DP-net CAPX-ΔNWC

WACC=wd×rd×(1-T)+w_s×r_s

    Excel functions: NPV, PV  

2. Since the cash flows from buy and lease have different risks, it is not good to discount them with the cost of debt or use NAL. I recommend student to consider the value of the project separately for the buy and the lease scenarios. Since Becky’s company has an optimal capital structure, the WACC approach is acceptable. However, leasing is equivalent to borrowing and may force the company to borrow less elsewhere, losing interest shield benefits.

Grading

7 points in total

Finished and submitted on time: 3 points

0-25% correct: +1

25%-50% correct: +2

50%-75% correct: +3

75%-100% correct: +4

***Please include all excel functions in answer***

Answer 1

Based on the given data, pls find below calculations:

Based on the below workings, it is recommeded to opt for leasing option as the NPV of the leasing option is higher than that of the purchase option;