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 $52,000 per year. 3. The firm's tax rate is 32% 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 $200,000, 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. X 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 $ Lease versus Buy Cost of machinery $1,000,000 Bank loan amount as % of cost 100.00% Year 4 7.41% Year 3 MACRS Depreciation Rates: Year Year 2 44.45% 33.33% 14.81% Estimated annual maintenance expenses $52,000 Length of lease term (in years) Annual end-of-year lease payments Lessee pays for insurance, property taxes, and maintenance 3 $280,000 Yes Machinery fair market value at Year 3 Firm's tax rate $200,000 32.00% Bank loan rate 12.00% Length of loan term (in years) for annual end-of-year payments 6 Borrow and Buy Analysis |Depreciation Schedule of New Machinery Depreciation expense Book value of new machinery Year 1 Year 2 Year 3 Year 4 $1,000,000 $1,000,000 $1,000,000 $1,000,000 Amortization Schedule of Loan Beginning loan balance Loan payment Interest payment Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 $1,000,000 $0 $0 $0 $0 $0 0 0 0 0 0 Principal payment Ending loan balance Cost of Owning Purchase price of machinery Loan proceeds Loan payments Interest tax savings Depreciation tax savings Year 0 Year 2 Year 5 Year 6 Year 1 Year 3 Year 4 0 0 0 Net cash flow $0 $0 $0 $0 $0 $0 $0 PV of ownership Depreciation Schedule of Used Machinery: Depreciation expense Book value of used machinery Year 0 Year Year 2 Year 3 Year 4 Year 5 Year 6 200,000 200,000 200,000 200,000 Cost of Leasing Machinery After-tax lease payment Fair market value of machinery Depreciation tax savings Year 1 Year 2 Year 3 $0 Year 0 Year 4 Year 5 Year 6 $0 $0 $0 $0 $0 $0 $0 $0 Net cash flow PV of leasing Net advantage of leasing Should the firm lease the machinery? Formulas Borrow and Buy Analysis Depreciation Schedule of New Machinery: Depreciation expense Book value of new machinery Year 1 Year 2 Year 3 Year 4 #N/A #N/A #N/A #N/A Amortization Schedule of Loan Beginning loan balance Loan payment Interest payment Principal payment Year 6 Year 1 Year 2 Year 3 Year 4 Year 5 #N/A #N/A #N/A #N/A #N/A #N/A #N/A #N/A #N/A #N/A #N/A #N/A #N/A Principal payment Ending loan balance #N/A #N/A #N /A #N /A #N/A #N/A #N /A #N/A #N/A #N/A #N/A #N/A Cost of Owning Year 2 Year 6 Year 0 Year Year 3 Year 4 Year 5 #N/A Purchase price of machinery Loan proceeds Loan payments Interest tax savings Depreciation tax savings #N/A #N/A #N /A #N/A #N/A #N/A #N/A #N/A #N/A #N/A #N/A #N/A #N/A #N/A Net cash flow PV of ownership #N/A Year 4 Year 5 Depreciation Schedule of Used Machinery: Depreciation expense Book value of used machinery Year 0 Year 1 Year 2 Year 3 Year 6 #N /A #N/A / #N /A Cost of Leasing Machinery After-tax lease payment Year 0 Year 2 Year 4 Year 6 Year 1 Year 3 Year 5 #N/A Fair market value of machinery Depreciation tax savings #N /A #N/A #N/A #N/A #N/A Net cash flow Net cash flow PV of leasing #N/A Net advantage of leasing #N/A 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 $52,000 per year. 3. The firm's tax rate is 32% 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 $200,000, 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. X 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 $ Lease versus Buy Cost of machinery $1,000,000 Bank loan amount as % of cost 100.00% Year 4 7.41% Year 3 MACRS Depreciation Rates: Year Year 2 44.45% 33.33% 14.81% Estimated annual maintenance expenses $52,000 Length of lease term (in years) Annual end-of-year lease payments Lessee pays for insurance, property taxes, and maintenance 3 $280,000 Yes Machinery fair market value at Year 3 Firm's tax rate $200,000 32.00% Bank loan rate 12.00% Length of loan term (in years) for annual end-of-year payments 6 Borrow and Buy Analysis |Depreciation Schedule of New Machinery Depreciation expense Book value of new machinery Year 1 Year 2 Year 3 Year 4 $1,000,000 $1,000,000 $1,000,000 $1,000,000 Amortization Schedule of Loan Beginning loan balance Loan payment Interest payment Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 $1,000,000 $0 $0 $0 $0 $0 0 0 0 0 0 Principal payment Ending loan balance Cost of Owning Purchase price of machinery Loan proceeds Loan payments Interest tax savings Depreciation tax savings Year 0 Year 2 Year 5 Year 6 Year 1 Year 3 Year 4 0 0 0 Net cash flow $0 $0 $0 $0 $0 $0 $0 PV of ownership Depreciation Schedule of Used Machinery: Depreciation expense Book value of used machinery Year 0 Year Year 2 Year 3 Year 4 Year 5 Year 6 200,000 200,000 200,000 200,000 Cost of Leasing Machinery After-tax lease payment Fair market value of machinery Depreciation tax savings Year 1 Year 2 Year 3 $0 Year 0 Year 4 Year 5 Year 6 $0 $0 $0 $0 $0 $0 $0 $0 Net cash flow PV of leasing Net advantage of leasing Should the firm lease the machinery? Formulas Borrow and Buy Analysis Depreciation Schedule of New Machinery: Depreciation expense Book value of new machinery Year 1 Year 2 Year 3 Year 4 #N/A #N/A #N/A #N/A Amortization Schedule of Loan Beginning loan balance Loan payment Interest payment Principal payment Year 6 Year 1 Year 2 Year 3 Year 4 Year 5 #N/A #N/A #N/A #N/A #N/A #N/A #N/A #N/A #N/A #N/A #N/A #N/A #N/A Principal payment Ending loan balance #N/A #N/A #N /A #N /A #N/A #N/A #N /A #N/A #N/A #N/A #N/A #N/A Cost of Owning Year 2 Year 6 Year 0 Year Year 3 Year 4 Year 5 #N/A Purchase price of machinery Loan proceeds Loan payments Interest tax savings Depreciation tax savings #N/A #N/A #N /A #N/A #N/A #N/A #N/A #N/A #N/A #N/A #N/A #N/A #N/A #N/A Net cash flow PV of ownership #N/A Year 4 Year 5 Depreciation Schedule of Used Machinery: Depreciation expense Book value of used machinery Year 0 Year 1 Year 2 Year 3 Year 6 #N /A #N/A / #N /A Cost of Leasing Machinery After-tax lease payment Year 0 Year 2 Year 4 Year 6 Year 1 Year 3 Year 5 #N/A Fair market value of machinery Depreciation tax savings #N /A #N/A #N/A #N/A #N/A Net cash flow Net cash flow PV of leasing #N/A Net advantage of leasing #N/A Should the firm lease the machinery? #N/A