Morris-Meyer Mining Company must install $1.5 million of new machinery in its Nevada mine. It can obtain a bank loan for 100% of the required amount. Alternatively, a Nevada investment banking firm that represents a group of investors believes that it can arrange for a lease financing plan. Assume that the following facts apply:
(1) The equipment falls in the MACRS 3-year class. The applicable MACRS rates are 33%, 45%, 15%, and 7%.
(2) Estimated maintenance expenses are $75,000 per year.
(3) Morris-Meyer’s federal-plus-state tax rate is 40%.
(4) If the money is borrowed, the bank loan will be at a rate of 15%, amortized in 4 equal installments to be paid at the end of each year.
(5) The tentative lease terms call for end-of-year payments of $400,000 per year for 4 years.
(6) Under the proposed lease terms, the lessee must pay for insurance, property taxes, and maintenance.
(7) Morris-Meyer 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, under the lease terms, it can purchase the machinery at its fair market value at that time. The best Chapter 20 Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles 649 estimate of this market value is the $250,000 salvage value, but it may be much higher or lower under certain circumstances. To assist management in making the proper lease-versus-buy decision, you are asked to answer the following questions.
a. Assuming that the lease can be arranged, should Morris-Meyer lease or borrow and buy the equipment? Explain.
b. Consider the $250,000 estimated salvage value. Is it appropriate to discount it at the same rate as the other cash flows? What about the other cash flows—are they all equally risky? Explain. (Hint: Riskier cash flows are normally discounted at higher rates; but when the cash flows are costs rather than inflows, the normal procedure must be reversed.)