Net advantage of leasing $

Less or greater, lease or buy

Yes or no.

Sadik Industries must install $1 million of new machinery in its Texas plant. It can obtain a bank loan for 100% of the required amount. Alternatively, a Texas investment banking firm that represents a group of investors believes that it can arrange for a lease financing plan. Assume that these facts apply: 1. The equipment falls in the MACRS 3-year class. 2. Estimated maintenance expenses are $50,000 per year. 3. The firm's tax rate is 30%. 4. If the money is borrowed, the bank loan will be at a rate of 12%, amortized in six equal installments at the end of each year. 5. The tentative lease terms call for payments of $280,000 at the end of each year for 3 years. The lease is a guideline lease. 6. Under the proposed lease terms, the lessee must pay for insurance, property taxes, and maintenance. 7. Sadik must use the equipment if it is to continue in business, so it will almost certainly want to acquire the property at the end of the lease. If it does, then under the lease terms it can purchase the machinery at its fair market value at Year 3. The best estimate of this market value is $210,000, but it could be much higher or lower under certain circumstances. If purchased at Year 3, the used equipment would fall into the MACRS 3-year class. Sadik would actually be able to make the purchase on the last day of the year (i.e., slightly before Year 3), so Sadik would get to take the first depreciation expense at Year 3 (the remaining depreciation expenses would be at Year 4 through Year 6). On the time line, Sadik would show the cost of the used equipment at Year 3 and its depreciation expenses starting at Year 3. Year 3-year MACRS 33.33% 44.45% 14.81 % 7.41% The data has been collected in the Microsoft Excel Online file below. Open the spreadsheet and perform the required analysis to answer the questions below. Open spreadsheet To assist management in making the proper lease-versus-buy decision, you are asked to answer the following questions: a. What is the net advantage of leasing? Should Sadik take the lease? Do not round intermediate calculations. Round your answer to the nearest dollar. Net advantage of leasing $ than the cost of owning it, the firm should Since the cost of leasing the machinery is the equipment. b. The decision almost can be considered a bet on the future residual value. Do you think the residual cash flows are equal in risk to the other cash flows? (Hint: if you discount a negative cash flow at a higher rate, you get a better NPV - the NPV of a negative cash flow stream is less negative at high discount rates.) 1 Lease versus Buy m Cost of machinery Bank loan amount as % of cost $1,000,000 100.00% MACRS Depreciation Rates: Year 1 33.33% Year 2 44.45% Year 3 14.81% Year 4 7.41% 550.000 Estimated annual maintenance expenses 10 Length of lease term (in years) 11 Annual end-of-year lease payments 12 Lessee pays for insurance, property taxes, and maintenance 13 Machinery fair market value at Year 3 14 Fimm's tax rate 15 Bank loan rate 16 Length of loan term (in years) for annual end-of-year payments $280.000 Yes $210.000 30.00% 12.00% 17 18 Borrow and Buy Analysis: 19 Depreciation Schedule of New Machinery 20 Depreciation expense 21 Book value of new machinery Year 1 $333,300 $666,700 Year 2 S 444,500 S222,200 Year 3 $148,100 $74,100 Year 4 $74.100 22 23 Amortization Schedule of Loan: 24 Beginning loan balance 25 Loan payment 26 Interest payment 27 Principal payment 28 Ending loan balance Year 1 $1,000,000 243.226 120,000 123.226 876,774 Year 2 $876,774 243,226 105,213 138,013 738,761 Year 3 $738,761 243,226 88,651 154,574 584,187 Year 4 S584,187 243,226 70,102 173,123 411,064 Year 5 $411,064 243 226 49,328 193.898 217,166 Year 6 $217,166 243.226 26,060 217.166 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 0 -$1.000.000 $1.000.000 30 Cost of Owning 31 Purchase price of machinery 32 Loan proceeds 33 Loan payments 34 Interest tax savings Depreciation tax savings 36 Net cash flow 243.226 243.226 243.226 243,226 243.226 243,226 35 99.990 $343.216 133,350 8376.576 44.43022230 $287.656 S265,456 0 $243.226 SO $243.226 37 38 PV of ownership 39 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 210,000 210,000 210.000 210,000 40 41 Depreciation Schedule of Used Machinery: 42 Depreciation expense 43 Book value of used machinery 44 45 46 Cost of Leasing Machinery: 47 After-tax lease payment 48 Fair market value of machinery 49 Depreciation tax savings 50 Net cash flow 51 52 PV of leasing Year 0 Year 1 Year 4 Year 5 Year 6 Year 2 Year 3 SOSO $0 $0 $0 $0 $ 0 S0S0 Net advantage of leasing Should the firm lease the machinery? Formulas 59 Borrow and Buy Analysis: 60 Depreciation Schedule of New Machinery 61 Depreciation expense 62 Book value of new machinery Year 1 =B3*C7 Year 2 =B3*D7 Year 3 =B3E7 Year 4 B3*F7 099898 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 64 Amortization Schedule of Loan: 65 Beginning loan balance 66 Loan payment 67 Interest payment 68 Principal payment 69 Ending loan balance =- PMT(B15.B 16.B3) =C24*SB$15 =$C$25-C26 =C24-C27 =D24*$B$15 =E24*SBS15 =F24*$B$15 =G24*SBS15 =H24*SBS15 =$CS25-D26 =$C$25-E26 =SCS25-F26 ESC$25-G26 =$C$25-H26 =D24-D27 E24-E27 =F24-F27 =G24-G27 =H24-H27 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 =-B3 =B3 71 Cost of Owning 72 Purchase price of machinery 73 Loan proceeds 74 Loan payments 75 Interest tax savings 76 Depreciation tax savings 77 Net cash flow =C25 #N/A =C20*$B$14 #NA #N/A #NA #N/A #N/A =D20*$B$14 =E20*SBS14 =F20*$BS14 =G20*$BS14 =H20*$B$14 78 PV of ownership #N/A 80 81 Year 0 Year 1 Year 2 82 Depreciation Schedule of Used Machinery: 83 Depreciation expense 84 Book value of used machinery Year 3 #N/A Year 4 #N/A Year 5 #N/A Year 6 #N/A Year 0 Year 2 Year 3 Year 4 Year 5 Year 6 Year 1 #N/A 87 88 89 90 91 Cost of Leasing Machinery: After-tax lease payment Fair market value of machinery Depreciation tax savings Net cash flow #NA #N/A #NA #N/A #N/A PV of leasing #N/A 94 Net advantage of leasing #N/A 96 97 Should the firm lease the machinery? #N/A Sadik Industries must install $1 million of new machinery in its Texas plant. It can obtain a bank loan for 100% of the required amount. Alternatively, a Texas investment banking firm that represents a group of investors believes that it can arrange for a lease financing plan. Assume that these facts apply: 1. The equipment falls in the MACRS 3-year class. 2. Estimated maintenance expenses are $50,000 per year. 3. The firm's tax rate is 30%. 4. If the money is borrowed, the bank loan will be at a rate of 12%, amortized in six equal installments at the end of each year. 5. The tentative lease terms call for payments of $280,000 at the end of each year for 3 years. The lease is a guideline lease. 6. Under the proposed lease terms, the lessee must pay for insurance, property taxes, and maintenance. 7. Sadik must use the equipment if it is to continue in business, so it will almost certainly want to acquire the property at the end of the lease. If it does, then under the lease terms it can purchase the machinery at its fair market value at Year 3. The best estimate of this market value is $210,000, but it could be much higher or lower under certain circumstances. If purchased at Year 3, the used equipment would fall into the MACRS 3-year class. Sadik would actually be able to make the purchase on the last day of the year (i.e., slightly before Year 3), so Sadik would get to take the first depreciation expense at Year 3 (the remaining depreciation expenses would be at Year 4 through Year 6). On the time line, Sadik would show the cost of the used equipment at Year 3 and its depreciation expenses starting at Year 3. Year 3-year MACRS 33.33% 44.45% 14.81 % 7.41% The data has been collected in the Microsoft Excel Online file below. Open the spreadsheet and perform the required analysis to answer the questions below. Open spreadsheet To assist management in making the proper lease-versus-buy decision, you are asked to answer the following questions: a. What is the net advantage of leasing? Should Sadik take the lease? Do not round intermediate calculations. Round your answer to the nearest dollar. Net advantage of leasing $ than the cost of owning it, the firm should Since the cost of leasing the machinery is the equipment. b. The decision almost can be considered a bet on the future residual value. Do you think the residual cash flows are equal in risk to the other cash flows? (Hint: if you discount a negative cash flow at a higher rate, you get a better NPV - the NPV of a negative cash flow stream is less negative at high discount rates.) 1 Lease versus Buy m Cost of machinery Bank loan amount as % of cost $1,000,000 100.00% MACRS Depreciation Rates: Year 1 33.33% Year 2 44.45% Year 3 14.81% Year 4 7.41% 550.000 Estimated annual maintenance expenses 10 Length of lease term (in years) 11 Annual end-of-year lease payments 12 Lessee pays for insurance, property taxes, and maintenance 13 Machinery fair market value at Year 3 14 Fimm's tax rate 15 Bank loan rate 16 Length of loan term (in years) for annual end-of-year payments $280.000 Yes $210.000 30.00% 12.00% 17 18 Borrow and Buy Analysis: 19 Depreciation Schedule of New Machinery 20 Depreciation expense 21 Book value of new machinery Year 1 $333,300 $666,700 Year 2 S 444,500 S222,200 Year 3 $148,100 $74,100 Year 4 $74.100 22 23 Amortization Schedule of Loan: 24 Beginning loan balance 25 Loan payment 26 Interest payment 27 Principal payment 28 Ending loan balance Year 1 $1,000,000 243.226 120,000 123.226 876,774 Year 2 $876,774 243,226 105,213 138,013 738,761 Year 3 $738,761 243,226 88,651 154,574 584,187 Year 4 S584,187 243,226 70,102 173,123 411,064 Year 5 $411,064 243 226 49,328 193.898 217,166 Year 6 $217,166 243.226 26,060 217.166 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 0 -$1.000.000 $1.000.000 30 Cost of Owning 31 Purchase price of machinery 32 Loan proceeds 33 Loan payments 34 Interest tax savings Depreciation tax savings 36 Net cash flow 243.226 243.226 243.226 243,226 243.226 243,226 35 99.990 $343.216 133,350 8376.576 44.43022230 $287.656 S265,456 0 $243.226 SO $243.226 37 38 PV of ownership 39 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 210,000 210,000 210.000 210,000 40 41 Depreciation Schedule of Used Machinery: 42 Depreciation expense 43 Book value of used machinery 44 45 46 Cost of Leasing Machinery: 47 After-tax lease payment 48 Fair market value of machinery 49 Depreciation tax savings 50 Net cash flow 51 52 PV of leasing Year 0 Year 1 Year 4 Year 5 Year 6 Year 2 Year 3 SOSO $0 $0 $0 $0 $ 0 S0S0 Net advantage of leasing Should the firm lease the machinery? Formulas 59 Borrow and Buy Analysis: 60 Depreciation Schedule of New Machinery 61 Depreciation expense 62 Book value of new machinery Year 1 =B3*C7 Year 2 =B3*D7 Year 3 =B3E7 Year 4 B3*F7 099898 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 64 Amortization Schedule of Loan: 65 Beginning loan balance 66 Loan payment 67 Interest payment 68 Principal payment 69 Ending loan balance =- PMT(B15.B 16.B3) =C24*SB$15 =$C$25-C26 =C24-C27 =D24*$B$15 =E24*SBS15 =F24*$B$15 =G24*SBS15 =H24*SBS15 =$CS25-D26 =$C$25-E26 =SCS25-F26 ESC$25-G26 =$C$25-H26 =D24-D27 E24-E27 =F24-F27 =G24-G27 =H24-H27 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 =-B3 =B3 71 Cost of Owning 72 Purchase price of machinery 73 Loan proceeds 74 Loan payments 75 Interest tax savings 76 Depreciation tax savings 77 Net cash flow =C25 #N/A =C20*$B$14 #NA #N/A #NA #N/A #N/A =D20*$B$14 =E20*SBS14 =F20*$BS14 =G20*$BS14 =H20*$B$14 78 PV of ownership #N/A 80 81 Year 0 Year 1 Year 2 82 Depreciation Schedule of Used Machinery: 83 Depreciation expense 84 Book value of used machinery Year 3 #N/A Year 4 #N/A Year 5 #N/A Year 6 #N/A Year 0 Year 2 Year 3 Year 4 Year 5 Year 6 Year 1 #N/A 87 88 89 90 91 Cost of Leasing Machinery: After-tax lease payment Fair market value of machinery Depreciation tax savings Net cash flow #NA #N/A #NA #N/A #N/A PV of leasing #N/A 94 Net advantage of leasing #N/A 96 97 Should the firm lease the machinery? #N/A