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GR Industries needs to expand its milling capacity and has selected a model that fits its needs. The first cost is $ 8 0 ,
GR Industries needs to expand its milling capacity and has selected a model that fits its
needs. The first cost is $ and the model is estimated to have a year economic
service life. The estimated salvage value after years is $ GR management believes
that the machine will increase its net beforetax cash flow by about $ per year. This
will give the company a beforetax inflated rate of return of about The companys
aftertax real minimum acceptable rate of return is and its tax rate is
Unfortunately, RG Industries does not have enough capital to buy the machine for cash, but it
can borrow $ from the bank. The loan would have to be repaid in eight endofyear
payments involving $ in principal per year, plus interest of on the unpaid debt at
the beginning of each year. If the machine is purchased, assume that it can be depreciated
using straightline depreciation over years, and that any gain when it is sold will be taxed
as ordinary income. Assume an inflation rate of per year.
The manufacturer of the new machine also offers a leasing program. The contract for the
lease requires a refundable deposit of $ which will be returned at the end of the
years. The annual rental payments are $ a year for years, payable at the beginning
of each year.
a If GR Industries had $ in cash to invest in the milling machine, whats the
aftertax inflated IRR? Whats the aftertax real rate? would it be a good
investment? Why or why not? Explain. Assume the machine can be sold for $
in year Hint: Use Excel. Solution: aftertax inflated IRR aftertax real
IRR
b Prepare a table showing aftertax cash flow for debt financing, and one for
leasing. Assume the machine can be sold for $ in year Can you compare
the aftertax real IRR of leasing vs loan directly? What would you recommend to
GR management? Explain. Solution: Loan is better with an aftertax real IRR
Aftertax real IRR for leasing
Note: The solution above assumes the first rent payment is an instantaneous
payment, ie there are no tax savings in year The optimal alternative might
change under a different assumption eg deferring the tax savings in year to year
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 offtheshelf solutions available
from other vendors?
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