Question
Lease analysis As part of its overall plant modernization and cost reduction program, the management of Tanner-Woods Textile Mills has decided to install a new
Lease analysis
As part of its overall plant modernization and cost reduction program, the management of Tanner-Woods Textile Mills has decided to install a new automated weaving loom. In the capital budgeting analysis of this equipment, the IRR of the project was 15% versus a project required return of 13%.
The loom has an invoice price of $230,000, including delivery and installation charges. The funds needed could be borrowed from the bank through a 4-year amortized loan at a 8% interest rate, with payments to be made at year-end. In the event the loom is purchased, the manufacturer will contract to maintain and service it for a fee of $18,000 per year paid at year-end. The loom falls in the MACRS 5-year class, and Tanner-Woods's marginal federal-plus-state tax rate is 35%. The applicable MACRS rates are 20%, 34%, 19%, 16%, 15%, and 5%.
United Automation Inc., maker of the loom, has offered to lease the loom to Tanner-Woods for $60,000 upon delivery and installation (at t = 0) plus 4 additional annual lease payments of $60,000 to be made at the end of Years 1 through 4. (Note that there are 5 lease payments in total.) The lease agreement includes maintenance servicing. Actually, the loom has an expected life of 10 years, at which time its expected salvage value is zero; however, after 4 years, its market value is expected to equal its book value of $41,000. Tanner-Woods plans to build an entirely new plant in 4 years, so it has no interest in leasing or owning the proposed loom for more than that period. Round your answers to the nearest dollar.
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Should the loom be leased or purchased?
PV cost of owning at 5.2% is $ .
PV cost of leasing at 5.2% is $ .
Tanner-Woods Textile should
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the loom.
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The salvage value is clearly the most uncertain cash flow in the analysis. Assume that the appropriate salvage value pretax discount rate is 13%. What would be the effect of a salvage value risk adjustment on the decision? Round your answer to the nearest dollar.
NPV is $ .
The firm should
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the loom.
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The original analysis assumed that Tanner-Woods would not need the loom after 4 years. Now assume that the firm will continue to use the loom after the lease expires. Thus, if it leased, Tanner-Woods would have to buy the asset after 4 years at the then existing market value, which is assumed to equal the book value. What effect would this requirement have on the basic analysis? (No numerical analysis is required; just verbalize.)
The firm would choose to
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as the net advantage.
Explain.
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