As part of its overall plant modernization and cost reduction program, Western Fabrics' management has decided to install a new automated weaving loom. In the capital budgeting analysis of this equipment, the IRR of the project was found to be 20% versus the project's required return of 12%.

The loom has an invoice price of $250,000, including delivery and installation charges. The funds needed could be borrowed from the bank through a 4-year amortized loan at a 10% interest rate, with payments to be made at the end of each year. In the event that the loom is purchased, the manufacturer will contract to maintain and service it for a fee of $20,000 per year paid at the end of each year. The loom falls in the MACRS 5-year class, and Western's marginal federal-plus-state tax rate is 40%.

Gardial Automation Inc., maker of the loom, has offered to lease the loom to Westen for $70,000 upon delivery and installation (at t=0) plus 4 additional annual lease payments of $70,000 to be made at the ends of Years 1 through 4. (Note that there are 5 lease payments in total.) The lease agreement includes maintenance and servicing. Actually, the loom has an expected life of eight 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 and entirely new plant in 4 years, so it has no interest in either leasing or owning the proposed loom for more than that period.

a. Should the loom be leased or purchased?

First, we want to lay out all of the input data in the problem.

INPUT DATA

Invoice Price

$250,000

Length of loan

4

Loan Interest rate

10%

Maintenance fee

$20,000

Tax Rate

40%

Lease fee

$70,000

Equipment expected life

8

Expected salvage value

$0

Market value after 4 years

$42,500

Book value after 4 years

$42,500

First, we can determine the annual loan payment that must be made on the new equipment. We will do so using the

function wizard for PMT.

Annual loan payment =

$78,868

Year

1

2

3

4

Beginning loan balance

$250,000

$275,000

$302,500

$332,750

Interest payment

$25,000

$27,500

$30,250

$33,275

Principal payment

($25,000)

($27,500)

($30,250)

($33,275)

Ending loan balance

$275,000

$302,500

$332,750

$366,025

Now, we see that the decision being made is whether to purchase the equipment at a net cost of $250,000 (with annual payments of $78,868) or lease the equipment and make annual payments of $70,000. To make this decision, we must analyze the incremental cash flows.

Before proceeding with our NPV analysis we must determine the schedule of depreciation charges for this new equipment.

MACRS 5-year Depreciation Schedule

Year

1

2

3

4

5

6

Depr. Rate

20.00%

32.00%

19.20%

11.52%

11.52%

5.76%

Depr. Exp.

$50,000

$80,000

$47,500

$30,000

$27,500

$15,000

We can now construct our table of incremental cash flows from these two alternatives. Remember, that the appropriate discount rate in this scenario is the after tax cost of borrowing, or: 10%*(1-40%) = 6%.

NPV LEASE ANALYSIS OF INCREMENTAL CASH FLOWS

Year =

0

1

2

3

4

Cost of ownership

Purchase cost

($250,000)

Loan proceeds

$250,000

After-tax interest payment

($15,000)

($11,768)

($8,213)

($4,302)

Principal payment

($53,868)

($59,255)

($65,180)

($71,698)

Maintenance cost

($20,000)

($20,000)

($20,000)

($20,000)

Tax savings from maintenance cost

$8,000

$8,000

$8,000

$8,000

Tax savings from depreciation

$20,000

$32,000

$19,000

$12,000

Salvage value

$42,500

Net cash flow from ownership

$0

($60,868)

($51,023)

($66,393)

($33,500)

PV cost of ownership

($185,113)

Cost of leasing

Lease payment

($70,000)

($70,000)

($70,000)

($70,000)

($70,000)

Tax savings from lease payment

$28,000

$28,000

$28,000

$28,000

$28,000

Net cash flow from leasing

($42,000)

($42,000)

($42,000)

($42,000)

($42,000)

PV cost of leasing

($187,534)

Cost Comparison

PV ownership cost @ 6%

$0

PV of leasing @ 6%

$0

Net Advantage to Leasing

Our NPV Analysis has told us that there is a negative advantage to leasing. We interpret that as an indication that the firm should forego the opportunity to lease and buy the new equipment.

b. The salvage value is clearly the most uncertain cash flow in the analysis. Assume that the appropriate salvage value pre-tax discount rate is 15 percent. What would be the effect of a salvage value risk adjustment on the decision?

All cash flows would remain unchanged except that of the salvage value. Our new array of cash flows would resemble the

following:

Standard discount rate

10%

Salvage value rate

15%

Year =

0

1

2

3

4

4

Net cash flow

$0

$0

$0

$0

$13,310

$42,500

PV of net cash flows

$0

$0

$0

$0

$10,543

$30,108

NPV of ownership

New Cost Comparison

PV ownership cost @ 6%

$0

PV of leasing @ 6%

$0

Net Advantage to Leasing

Under this new assumption of using a greater discount factor for the salvage value, we find that the firm should lease, and not buy, the equipment.

c. Assuming that the after-tax cost of debt should be used to discount all anticipated cash flows, at what lease payment would the firm be indifferent to either leasing or buying?

We will use the Goal Seek function to determine the lease payment that makes the Net Advantage to Leasing zero.

Crossover =

$69,175