Question
Investment Decision Mr. Stark is currently weighing his options for new manufacturing equipment he is considering for his expansion of production operations. He is currently
Investment Decision
Mr. Stark is currently weighing his options for new manufacturing equipment he is considering for his expansion of production operations. He is currently working out a deal with Thanos Inc.; a US competitor that is offering to lease brand new equipment it had acquired to CHI. Mr. Stark is also considering just purchasing the equipment up front from the original equipment manufacturer. He is trying to understand why Thanos Inc. would lease equipment to CHI, and what the benefits and drawbacks of leasing would potentially have for CHI. He also wants to know what type of lease is being considered, and what the effects would be on CHI's statement of financial position. He wants this to be included in your report.
CHI is considering investing in new manufacturing equipment that would cost $7.5M if purchased today from the original manufacturer. The CCA rate applicable to this asset is 30%. Alternatively, CHI could lease the equipment for $1.64M annually over a six year term, with payments at the beginning of each year. The salvage value is expected to be $900,000 at the end of six years, according to CHI's CFO Justin Hammer, and the disposal of the assets will not trigger any tax effects. The applicable tax rate is 25%. The lease term is a major part of the estimated economic life of the equipment.
Mr. Stark wants your advice on whether or not CHI should purchase or lease the asset. He wants you to determine the effect of having payments at the end of the year, rather than at the beginning of the year. He also believes that the salvage value estimation by Justin Hammer is incorrect, and that the salvage value could be as high as $1.2M after six years. He wants to know how a salvage value of $1.2M will impact the purchase or leasing decision, when payments are either at the beginning or end of a period. Thanos Inc. has also offered to have lease payments at the end of each period as long as CHI puts up a $200K security deposit. Mr. Stark wants you to evaluate the impact of the security deposit option.
After Tax cost of debt is 3%
WACC is 5.54%, use as discount rate.
Use Net Advantage to Leasing (NAL) for analysis.
1 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
a) changes in payments from beginning of period to end;
b) changes in salvage value;
c) security deposit; and
d) the break-even lease payment.
Also, explain and evaluate if the investment should be purchased or leased, depending on the different scenarios analyzed and determine the classification of the lease option being considered, and indicate what the effect would be on the statement of financial position.
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