Question

Sadik Industries must install $1 million of new machinery in its Texas plant. It can obtain a bank loan for 100% of the required amount. Alternatively, a Texas investment banking firm that represents a group of investors believes that it can arrange for a lease financing plan. Assume that these facts apply: The equipment falls in the MACRS 3-year class. Estimated maintenance expenses are $50,000 per year. The firm's tax rate is 40%. If the money is borrowed, the bank loan will be at a rate of 12%, amortized in six equal installments at the end of each year. The tentative lease terms call for payments of $280,000 at the end of each year for 3 years. The lease is a guideline lease. Under the proposed lease terms, the lessee must pay for insurance, property taxes, and maintenance. Sadik must use the equipment if it is to continue in business, so it will almost certainly want to acquire the property at the end of the lease. If it does, then under the lease terms it can purchase the machinery at its fair market value at Year 3. The best estimate of this market value is $200,000, but it could be much higher or lower under certain circumstances. If purchased at Year 3, the used equipment would fall into the MACRS 3-year class. Sadik would actually be able to make the purchase on the last day of the year (i.e., slightly before Year 3), so Sadik would get to take the first depreciation expense at Year 3 (the remaining depreciation expenses would be at Year 4 through Year 6). On the time line, Sadik would show the cost of the used equipment at Year 3 and its depreciation expenses starting at Year 3. Year 3-year MACRS 1 33.33 % 2 44.45 % 3 14.81 % 4 7.41 %

To assist management in making the proper lease-versus-buy decision, you are asked to answer the following questions:

1. What is the net advantage of leasing? Should Sadik take the lease? Do not round intermediate calculations. Round your answer to the nearest dollar.

   Net advantage of leasing $  

   Since the cost of leasing the machinery is _________lessgreater than the cost of owning it, the firm should _______leasebuy the equipment.

2. The decision almost can be considered a bet on the future residual value. Do you think the residual cash flows are equal in risk to the other cash flows? (Hint: if you discount a negative cash flow at a higher rate, you get a better NPV — the NPV of a negative cash flow stream is less negative at high discount rates.)

Answer 1

loan	leasing
Vf                            =1404928 total                       =1404928	Cost: 280000 x 3           = 840000 Purchase value               = 200000 Depreciation Expenses = 148100 total                                =1008100

What is the net advantage of leasing? Should Sadik take the lease? Do not round intermediate calculations. Round your answer to the nearest dollar.

The advantage of the lease is that at the end of the contract, the machinery is at the disposal of the lessee if he so wishes, likewise the expenses generated by the depresion expenses and others are assumed by the firm until the end of the contract, if it should take the arrendment

Net lease advantage $

Since the cost of leasing the machinery is $ 1,008,100 less than the cost of owning it, the company should purchase the equipment.

The decision can almost consider a bet on future residual value. Do you think residual cash flows have the same risk as the other cash flows? (Hint: If you discount negative cash flow at a higher rate, you get a better NPV - the NPV of negative cash flow is less negative at high discount rates.)

They do not have it since they work with a much less fluctuating and more stable base, therefore future flows will be established with greater accuracy based on the security of the tangible.

The risk in these cash flows decreases, therefore the interest rate of the NPV will also decrease, which translates into a moderate or very controlled risk

note; additional expenses are not part of the choice since each of these are generated equally depending on the proportion they handle.

• part of the tax rate is applied to earnings for the period
• On the part of the depreciation expenses, these are the same for the two options since they must incur these as long as the property is clearly owned by the company, likewise the cost of the loan must include it but for the purposes of the calculation it was not made