Assignment 3: Case Study - America Coffee House

It is January 1st, 2018. You are a senior analyst at America Coffee House Inc. (ACH), a leading coffee chain and wholesaler of coffee/bakery products in North America. The CEO of America Coffee House, Susan Matthews, has reached out to you to look at two options regarding an investment, building on your analysis from Assignment 1 and Assignment 2.

Purpose

Under this case approach, you will demonstrate your ability to undertake a detailed analysis to evaluate the buy versus lease options for an investment proposal, on a qualitative and quantitative basis. You will also be required to calculate the weighted average cost of capital (WACC). A supplementary scenario analysis of leasing options is required.

How to Proceed

1. Create a title page with your purchase versus lease report name and author identification.
3. Explain the advantages and disadvantages of leasing, including the possible reasons, right or wrong, that would make a company lease an asset (from the lessor and lessee perspective).
5. Calculate the weighted average cost of capital (WACC) to use in your net advantage to leasing (NAL) analysis, rounding to the nearest one tenth of a percent.
7. Prepare your Net Advantage to Leasing analysis of the investment using the WACC as the discount rate. In addition, determine the impacts of the sensitivity analysis in the case, including
   1. changes in payments from beginning of period to end;
   2. changes in salvage value;
   3. security deposit; and
   4. the break-even lease payment.
9. Explain and evaluate if the investment should be purchased or leased, depending on the different scenarios analyzed.
11. Determine the classification of the lease option being considered, and indicate what the effect would be on the statement of financial position.

Format for Submission

• Your report narratives may be done in Word or Excel, but calculations and tables of values must be prepared in Excel with the amounts derived from actual formulas that use your variables, rounded to four (4) decimals or lower.
• The Excel tab worksheet must be print and presentation ready, formatted to print in 2 to 3 pages without page fragmentation of equations or tables between pages.
• It is permissible to break your report down using the questions listed above as headings.
• Submit your report file(s) into the Assignment 3: Case Study dropbox on UM Learn.

Your assignment must be submitted by the deadline date found in the course schedule provided in the Course Outline.

Grading

You will be assessed in accordance with the following rubric:

Q1	Title Page, Readability, Format, Spelling and Grammar	Marks	Student
	Title Page, Readability, Format, Spelling & Grammar	12
Q2	Qualitative Discussion of Leasing vs. Purchasing	Marks	Student
	Advantages vs. Disadvantages	4
	Reasons for Lessor to lease (at least three)	4
	Reasons for Lessee to lease (at least three)	4
Q3	WACC Calculation	Marks	Student
	Weighted Cost of Equity
	Growth Calculation	3
	Dividend/Stock calculation	3
	Calculation of $ amount of Common Equity	2
	Calculation of weight in capital of Common Equity	2
	Weighted Cost of Debt
	After-tax cost of debt	3
	Calculation of weight in capital of Debt	2
	Weighted Cost of Preferred Equity
	Cost of Preferred Stock	3
	Calculation of weight in capital of Preferred Stock	2
	WACC Calculation completed	4
Q4	Financial Forecast	Marks	Student
	Initial Analysis
	WACC utilized as discount rate	2
	Correct term applied	2
	Correct use of initial investment	2
	After-tax leasing payments calculated	2
	Present value of after-tax leasing payments	2
	Tax Shield calculation	6
	Present value of Salvage value	2
	Lease payments at beginning of period	2
	Scenario Analysis
	A. Change in payments from beginning to end	4
	B. Changes in Salvage Value	4
	C. Impact of Security Deposit with end payments	4
	D. Breakeven lease payment	4
Q5	Evaluation of Leasing Options	Marks	Student
	Recommendation for original option - lease or buy	2
	Recommendation for scenarios:
	Change in payments	2
	Changes in salvage value	2
	Security deposit impact	2
Q6	Lease Classification	Marks	Student
	Determines correct leasing classification	4
	Discusses impact on financial statements	4
Total		100	0

America Coffee House Case Study

Investment Decision

Ms. Matthews is currently weighing her options for new refrigeration equipment she is considering for her expansion of frozen yogurt offerings. This equipment would be important for distribution and storage facilities to store yogurt before delivery to retail operations. She is currently working out a deal with Blizzard Inc.; a US ice cream manufacturer that is offering to lease brand new equipment it has acquired to ACH. Ms. Matthews is also considering just purchasing the equipment up front from the original equipment manufacturer. She is trying to understand why Blizzard Inc. would lease equipment to ACH, and what the benefits and drawbacks of leasing would potentially have for ACH. She also wants to know what type of lease is being considered, and what the effects would be on ACH's statement of financial position. She wants you to include this information in your report.

ACH is considering investing in new manufacturing equipment that would cost $10M if purchased today from the original manufacturer. The CCA rate applicable to this asset is 35%. Alternatively, ACH could lease the equipment for $2.15M annually over a six year term, with payments at the beginning of each year. The salvage value is expected to be $1,500,000 at the end of six years, according to ACH's CFO Justine Brown, and the disposal of the assets will not trigger any tax effects. The applicable tax rate is 25%. At the end of the lease, ACH has the option to purchase the equipment at a bargain price.

Ms. Matthews wants your advice on whether or not ACH should purchase or lease the asset. She wants you to determine the effect of having payments at the end of the year, rather than at the beginning of the year. She also believes that the salvage value estimation by Justine Brown is incorrect, and that the salvage value could be as high as $2.7M after six years. She wants to know how a salvage value of $2.7M will impact the purchase or leasing decision, when payments are either at the beginning or end of a period. Blizzard Inc. has also offered to have lease payments at the end of each period, as long as ACH puts up a $800K security deposit. Ms. Matthews wants you to evaluate the impact of the security deposit option.

Finally, Ms. Matthews wants to know what lease payment would effectively lead to indifference between leasing and purchasing, under the original offer (i.e., six payments at the beginning of the year and a $1.5M salvage value).

After taking these scenarios into account, Ms. Matthews would like you to recommend what ACH should ultimately do.

Weighted Average Cost of Capital (WACC)

Ms. Matthews wants you to use the weighted average cost of capital (WACC) as the required return. ACH currently has 10 million common shares that are trading at $30 per share. The dividend is expected to increase to $3.00 per share in the next period. ACH also has 1 million preferred shares that get $1M in dividends and are currently trading at $20 per share. Ms. Matthews wants you to determine the cost of preferred equity and common equity, using dividends and share prices. The anticipated constant growth rate for common dividends is 2%.

The total market value of debt ACH expects to have going into this investment is $120M. The before-tax cost of debt is approximately 8%, excluding the impact of re-financing at a lower rate of 6% for $50M. Ms. Matthews wants you to use the 8% interest rate as the proxy for the cost of debt, but needs you to determine the after-tax cost of debt to be used in the WACC. A tax rate of 25% has been suggested for use in the analysis.