Question

Two firms, Cruella Inc. and Morticia Corporation, are considering the installation of an automated sun-blocking system in their respective headquarters. The system costs $10,000,000, and both firms would depreciate on a straight-line basis to a zero salvage value over an expected 5-year life. The expected salvage value on the system is $500,000 at the end of year 5. It is the policy of each firm to discount salvage values at their respected WACCs. If the firms purchase the system, the annual maintenance expenses are expected to be $125,000. Alternatively, the system can be leased for $2,650,000 due at the beginning of each year, and the lessor would be responsible for maintenance costs. Although the two firms have similar sun-blocking needs, their financial conditions differ significantly. Cruella has had difficulties recently, and therefore has a 0% effective tax rate, an annual cost of borrowing of 16%, and a WACC of 19.5%. Morticia is highly profitable, and therefore has a marginal tax rate of 40%, an annual cost of borrowing of 12%, and a WACC of 15%. Compute the NAL for each firm.

Answer 1

1	Cruella Inc
	WACC	19.50%
	Tax	0%
	Total Outflow of Fund on Purchasing Option
	Purchase Cost	10,000,000
	Inflow from salvage value (WN-1)	(205,000)
	Annual maintenance expenses for 5 yr WN-2	378,000
	Total Outflow of Fund on Purchasing Option	10,173,000
	WN-1
	WACC	19.50%
	19.5% for 5 years (500000*.410)	205,000
	WN-2
	Annual maintenance expenses	125,000
	Present value annuty factor 19.5%	3.024
	Total	378,000
	No Depreciation for Cruella so there is no Tax effect on Depreciation
	Total Outflow of Fund on leasing option
	Present value of annual lease rental	9,575,672
	Annual Lease rental	2,650,000
	Year	Cash Flow	PVF	PV of cash flow
	0	2,650,000	1	2,650,000
	1	2,650,000	0.837	2,217,573
	2	2,650,000	0.700	1,855,710
	3	2,650,000	0.586	1,552,895
	4	2,650,000	0.490	1,299,494
	5	-	0.410	-
				9,575,672
	For Cruella Company Outflow less is Leasing option so Better is leasing
	Total Outflow of Fund on Purchasing Option	10,173,000
	Present value of annual lease rental	9,575,672
	Total Savings	597,328
2	Morticia Corporation
	WACC	15%
	Tax	40%
	Total Outflow of Fund on Purchasing Option
	Purchase Cost	10,000,000
	Inflow from salvage value (WN-1)	(248,500)
	Annual maintenance expenses for 5 yr WN-2	251,400
	Tax Savings on depreciation (WN-3)	(2,681,600)
	Total Outflow of Fund on Purchasing Option	7,321,300
	WN-1
	WACC	15%
	15% for 5 years (500000*.497)	248,500
	WN-2
	Annual maintenance expenses	125,000
	After Tax expenses(125000-40%)	75,000
	Present value annuty factor 15%	3.352
	Total	251,400
	WN-3
	Depreciation	2,000,000
	Tax Savings	800,000
	15% for 5 years Annuty Factor	3.352
	Tax Savings on depreciation	2,681,600
	Total Outflow of Fund on leasing option
	Present value of annual lease rental after tax	6,662,408
	Annual Lease rental	2,650,000
	Year	Cash Flow	Tax	Lease rent after tax	PVF	PV of cash flow
	0	2,650,000	0	2,650,000	1	2,650,000
	1	2,650,000	1060000	1,590,000	0.870	1,382,609
	2	2,650,000	1060000	1,590,000	0.756	1,202,268
	3	2,650,000	1060000	1,590,000	0.658	1,045,451
	4	2,650,000	1060000	1,590,000	0.572	909,088
	5	-	1060000	(1,060,000)	0.497	(527,007)
						6,662,408
	Lease Rent paying in advance(begning of the year) so tax will deduct in second year
	For Morticia Corporation Outflow less is Leasing option so Better is leasing
	Total Outflow of Fund on Purchasing Option	7,321,300
	Present value of annual lease rental after tax	6,662,408
	Total Savings	658,892