GR Industries needs to expand its milling capacity and has selected a model that fits its

needs. The first cost is $$80,000,$ and the model is estimated to have a $12-$year economic

service life. The estimated salvage value after $12$ years is $$5,000.$ GR management believes

that the machine will increase its net before$-$tax cash flow by about $$18,000$ per year. This

will give the company a before$-$tax inflated rate of return of about $20\%.$ The company$$s

after$-$tax real minimum acceptable rate of return is $12\%,$ and its tax rate is $40\%.$

Unfortunately, RG Industries does not have enough capital to buy the machine for cash, but it

can borrow $$60,000$ from the bank. The loan would have to be repaid in eight end$-$of$-$year

payments involving $$7,500$ in principal per year, plus interest of $12\%$ on the unpaid debt at

the beginning of each year. If the machine is purchased, assume that it can be depreciated

using straight$-$line depreciation over $10$ years, and that any gain when it is sold will be taxed

as ordinary income. Assume an inflation rate of $5\%$ per year.

The manufacturer of the new machine also offers a leasing program. The contract for the

lease requires a refundable deposit of $$8,000,$ which will be returned at the end of the $12$

years. The annual rental payments are $$12,000$ a year for $12$ years, payable at the beginning

of each year.

$($a$)$ If GR Industries had $$80,000$ in cash to invest in the milling machine, what$$s the

after$-$tax inflated IRR? What$$s the after$-$tax real rate? would it be a good

investment? Why or why not? Explain. Assume the machine can be sold for $$7,500$

in year $12.$ Hint: Use Excel. Solution: after$-$tax inflated IRR $=13\mathrm{.}5\%,$ after$-$tax real

IRR $=8\mathrm{.}1\%.$

$($b$)$ Prepare a table showing after$-$tax cash flow for debt financing, and one for

leasing. Assume the machine can be sold for $$7,500$ in year $12.$ Can you compare

the after$-$tax real IRR of leasing vs loan directly? What would you recommend to

GR management? Explain. Solution: Loan is better with an after$-$tax real IRR $=$

$15\mathrm{.}32\%.$ After$-$tax real IRR for leasing $=11\mathrm{.}7\%.$

Note: The solution above assumes the first rent payment is an instantaneous

payment, i$.$e$.,$ there are no tax savings in year $0.$ The optimal alternative might

change under a different assumption $($e$.$g$.,$ deferring the tax savings in year $0$ to year

$1).$

$($c$)$ Is the increase in revenue from buying the machine big enough to cover the required

cash flows for your recommended decision?

$($d$)$ What other factors should GR Industries consider in determining whether this

machine meets its needs, and comparing it with off$-$the$-$shelf solutions available

from other vendors?