GIVEN INFORMATION: BUY: First years added revenue was estimated to be $75,000; thereafter, revenues would increase by the rate of inflation, 5 percent. Purchase of the machine would save $79,000 in salaries and benefits. Internal rate of return of 16.2 percent over four years The company used a 12.7 percent after-tax cost of capital. o for projects of such low risk, the project clearly was worth undertaking Invoice price of $1,250,000. (NIV) Asset would be depreciated over four years using MACRS: o (annual depreciation rates of 33, 45, 15, and 7 percent) Purchase price (1,250,000) borrowed on a four-year amortized note. The loan would carry an interest rate of 11.5 percent with annual principal and interest payments. If purchases the equipment, the manufacturer will provide maintenance services for a fee of $75,000 per year. Machine is expected to have a useful life of six years LEASE: Lease the duplicator for four years Lease requires and annual payment of $425,000, payable at the beginning of the year, and also provides for maintenance In four years, the selling price at the time is estimated to be $65,000. Lease Plan views leasing as an alternative to lending the funds at 9 percent. Lease Plan has a marginal tax rate of 38 percent. Hamlin marginal tax rate is only 20 percent. what is the after-tax cost of debt? o KWACC Cost of debt = 11.5% *(1 20%) = 11.5% * 0.8 = 9.2% o IRR for the machine = 16.2% over 4yrs Cost of capital (post tax) or equity return = 12.7% Loan rate = 11.5% Marginal tax rate = 20% Cost of debt = 11.5% *(1 20%) = 11.5% * 0.8 = 9.2% If you were Skip and Marvin Hamlin, would you purchase or lease the equipment? QUESTIONS 1.Calculate the net present value of leasing the equipment (also known as the net advantage of leasing) from the Hamlin brothers point of view. Do you recommend that Hamlin purchase or lease the equipment? 2. What lease payment would make Hamlin in different between leasing and purchasing? (Hint: you need to set the NPV of leasing calculated in part 1 equal to zero by changing lease payments.) 3. Skip Hamlin recognizes that the analysis is influenced by the selection of the uncertain salvage value of the duplicator in year 4. The equipment could be worth the values below. What is the highest, lowest, and expected NPV of leasing using these data? What is the effect of salvage value on the NPV of the lease? How does this information affect your recommendation? Salvage Value Probability $12,500 20 $65,000 50 $100,000 30 4. Suppose you learned that Hamlins tax rate was about to increase substantially. What effect would this have on NPV of leasing? 5. Interest rates have been very volatile lately. Skip Hamlin thinks that rates could increase to 12.5 percent or decrease to 10.5 percent within the next few weeks. He also expects the lease payment to change if the interest rates change. The table below illustrates his expectations. Analyze the effects of potential interest rate changes. What is the highest and lowest NPV of leasing? (Maintain the tax rate and the salvage value at their most likely levels.) Interest Rate Lease Payment 10.5% $400,000 11.5% $425,000 12.5% $450,000 6. Evaluate the lease from Lease Plans point of view. What is the NPV of the lease and internal rate of return? (Hint: Cash flows from lease to Lease Plan will be exactly the same as to Hamlin, but with opposite sign. Also Lease Plan has a higher tax rate and lower cost of debt.) 7. At what lease payment does Lease Plan earn exactly 9 percent? (Hint: as in part 2, you need to set the NPV of leasing equal to zero by changing lease payments.) 8. What is the range of negotiation on the lease payment?