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 $54,000 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 13%, 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 $230,000, 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
1	33.33	%
2	44.45	%
3	14.81	%
4	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:

1. 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 $

   Since the cost of leasing the machinery is _________lessgreater than the cost of owning it, the firm should _______leasebuy the equipment.

2. 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.)

   _____Yes.No.

A B D Lease versus Buy Cost of machinery $1,000,000 100.00% Bank loan amount as % of cost MACRS Depreciation Rates: Year 1 Year 2 Year 3 Year 4 14.81% 33.33% 44.45% 7.41% 8 Estimated annual maintenance expenses Length of lease term (in years) 11 Annual end-of-year lease payments Lessee pays for insurance, property taxes, and maintenance 13 Machinery fair market value at Year 3 14 Firm's tax rate $54,000 3 10 $280,000 Yes 12 $230,000 30.00% Bank loan rate 13.00% 15 Length of loan term (in years) for annual end-of-year payments 6 16 17 Borrow and Buy Analysis: Depreciation Schedule of New Machinery: 18 Year 2 Year 3 Year 4 Year 1 10 D G Depreciation expense Book value of new machinery 20 $1.000.000 $1,000,000 $1.000.000 $1,000,000 21 22 23 Amortization Schedule of Loan: 24 Beginning loan balance Loan payment 26 Interest payment Principal payment 28 Ending loan balance Year $1,000,000 Year 2 S0 Year 3 Year 4 Year 5 Year 6 $0 $0 SC 0 0 0 0 25 27 20 Cost of Owning Purchase price of machinery Loan proceeds Loan payments Interest tax savings 35 Depreciation tax savings Net cash flow Year 0 Year 2 Year 6 Year 1 Year 3 Year 4 Year 5 30 31 32 0 0 0 34 36 $0 S0 SO SO $0 50 S0 37 PV of ownership 38 30 4 Depreciation Schedule of Used Machinery: Depreciation expense Book value of used machinery Year 0 Year 2 Year 6 Year 1 Year 3 Year 4 Year 5 41 230,000 230,000 230,000 230,000 43 14 4 Cost of Leasing Machinery r-tax lease payment Year 3 Year 4 Year 5 Year 6 Year 0 Year 1 Year 2 46 $0 $0 Fair marker value of machinery 49 Dep Net cash flow savings 50 S0 $0 $0 $0 $0 SO $0 51 PV of leasing 54 Net advantage of leasing 55 Should the firm leaca the machinan2