Your production manager just came into your office with a worried look. We are missing a lot of delivery commitments while we are repairing that old dust collector. If we want to keep our factory running smoothly, we have to replace it. Right now, we are facing fines and higherabsenteeism due to sickness because of how dusty it is in here.

Your schedule is hectic today, but you know that factory productivity is plummeting and tempers have grown short over the distraction of an unreliable piece of equipment. One thing is clear: you need a replacement right away. You call two industrial equipment dealers and ask for quotes on a new dust collection system. Your only requirement is that, since you lack the cash on hand to make a major purchase anytime soon, you want proposals that allow you to spread the payments over time. Both dealers promise to have bids to you in a week.

As you read the proposals the following week, you are not sure what to do. Alpha Equipment is offering a 4-year lease on the AirSweep 1000. The lease is for $16,275 annually payable in arrears, totaling $65,100 over the four years. The lease includes coverage for all major maintenance; but you estimate that you will pay an additional $1,300 annually for incidental maintenance items not covered by the lease.

Beta Air Handling Corporations proposal is different: They are offering to sell an AirSweep 1000 to you outright for $62,100. But, knowing that you cant pay for it all at once, Beta offers to finance the entire purchase price at 8.2% interest over four years, with equal annual principal installment payments of $15,525 in arrears plus interest. They also quote a separate major maintenance contract of $1,099 per year for the first year, with an annual renewal clause that includes a 3% annual fee increase. No one at your company has the time or skill to do heavy maintenance of the dust collector, so you know you will have to purchase the add-on maintenance contract. You further estimate that non-covered incidental maintenance will cost $600 every year you own the machine.

You decide to gather a few facts and then analyze both proposals to find the one that has the lower cost/higher NPV. First, you estimate that the Present Value today of avoided fines, sick leave, and medical expenses attributable to the new dust collector is $70,000. This represents a benefit (i.e., cash inflow) at time t=0.

Also, you know that many of the expenses you will pay are tax deductible, meaning that you can reduce the income tax you would have paid otherwise because of expenses associated with equipment use. You decide to discount the cash flows of both proposals by the opportunity cost of funds, which you conclude is the after-tax cost of the proposed 8.2% loan. Since your tax rate is 30%, this means your discount rate is 5.74%. (Your overall profit plan for the next four years, of which the dust collection costs are a small part, exceeds $300,000 annually, so you are certain that you will be able to take full advantage of any tax deductions you may make.)

Your experience tells you that constant usage will lead to wear and tear sufficient that you will not want the dust collector after four years. If you choose the lease, the lessor will simply take the dust collector back at the end of the 4-year lease. If you own the dust collector, you figure that you can sell it for parts to a smaller workshop at the end of 4 years for 10% of its original purchase price.

Your accounting manager lets you know that, if you buy the dust collector, a special tax incentive program will allow you to depreciate it for tax purposes in a straight line over 2 years (meaning depreciation expense equal to one-half of the purchase price for years 1and 2). But if you then sell the dust collector for more than its depreciated book value (which is your intention), you will have to pay a capital gains tax at that time of 20% of the difference between the actual sale proceeds and the depreciated value of zero.

Just before you start your analysis, you make a few lists to help with this decision. One list is of non-cash charges that are nevertheless tax deductible. The next list is of balance sheet cash flows that have no tax impacts, like the t=0 purchase price (outflow) of $62,100, the original loan (inflow) of $62,100, and the four annual principal repayment outflows. And you continue with a list of cash expenses that will reduce your taxable income, like the major maintenance contract, the incidental upkeep, the 8.2% interest on the loan, and the lease payments.

After you build a lease case and a buy case, you come to a decision.

Questions:

A. Build a 4-year pro forma cash flow statement for the lease case and determine its NPV.

2. Build a 4-year pro forma cash flow statement for the buy case and determine its NPV.

3. What salvage value (to the nearest tenth of a percent or xx.x% of original purchase price) makes you indifferent between the two cases?

Modeling Notes for Case 1:

Use the spreadsheet Assign#5_MiniCaseTemplate_Blended.xlsx to complete your analysis.Rename it and submit it when you are done.

To aid in your analysis, please assume all cash flows occur at the end of each relevant period (except the original loan and the dust collection system purchase price, which occur at t=0; and the $70,000 imputed benefit cash inflow, also at t=0). Assume interest is paid on the preceding loan balance, and that you then remit both the principal and interest at the same time (year-end). For example, your first (t=1) principal payment will be one-fourth of the loan amount; and your t=1 interest payment will be 8.2% times the previous balance, in this case, $62,100; the following year, the interest will be on the now-lower loan balance.

Question 1 Parts A&B (A) Leasing Option $65,100 Four Equal Annual Payments of $16,275 in Arrears Tax Rate After-tax Cost of Debt (Discount Rate) 30% 5.74% Today End of year 3 4 $70,000 PV of Avoided Costs Tax Rate 30% 30% 30% 30% Lease Payment ($16,275) ($16,275) ($16,275) ($16,275) NPY of Leasing Option $0 NPV of Leasing Option $0 (B) Purchase Option Depreciable Life (Straight Line) Purchase Price Initial Annual Maintenance Maintenance Escalator In-House Maint. Costs Salvage Value Capital Gains Tax Debt Amortization Pre-tax Cost of Debt Income Tax Rate After-tax Cost of Debt (Discount Rate) 2 years $62,100 $1,099 3.0% $600 10.0% of Purch. 20% 4 years 8.20% 30% 5.74% = End of year End of year 3 a 4 a PV of Avoided Costs Borrowed Funds Inflow Purchase Price Tax Rate Today $70,000 62,100 (62,100) 30% 30% 30% 30% 30% 30% Question 1 Part C (A) Leasing Option $65,100 Four Equal Annual Payments of $16,275 in Arrears Tax Rate After-tax Cost of Debt (Discount Rate) 30% 5.74% Today 1 End of year End of year a 1 PV of Avoided Costs Tax Rate $70,000 30% 30% 30% 30% Lease Payment ($16,275) ($16,275) ($16,275) ($16,275) NPV of Leasing Option $0 (B) Purchase Option Depreciable Life (Straight Line) Purchase Price Initial Annual Maintenance Maintenance Escalator In-House Maint. Costs Salvage Value Capital Gains Tax Debt Amortization Pre-tax Cost of Debt Income Tax Rate After-tax Cost of Debt (Discount Rate) ??? 2 years $62,100 $1,099 3.0% $600 of Purch. 20% 4 years 8.20% 30% 5.74% End of year End of year Today $70,000 62,100 (62,100) PV of Avoided Costs Borrowed Funds Inflow Purchase Price Tax Rate b C 30% 30% 30% 30% 30% 30% 30% 30% NPV of Purchase Option Memo: Debt Balance $62, 100 Lease $0 Buy NPVs SO Therefore, choose: Buy Question 1 Parts A&B (A) Leasing Option $65,100 Four Equal Annual Payments of $16,275 in Arrears Tax Rate After-tax Cost of Debt (Discount Rate) 30% 5.74% Today End of year 3 4 $70,000 PV of Avoided Costs Tax Rate 30% 30% 30% 30% Lease Payment ($16,275) ($16,275) ($16,275) ($16,275) NPY of Leasing Option $0 NPV of Leasing Option $0 (B) Purchase Option Depreciable Life (Straight Line) Purchase Price Initial Annual Maintenance Maintenance Escalator In-House Maint. Costs Salvage Value Capital Gains Tax Debt Amortization Pre-tax Cost of Debt Income Tax Rate After-tax Cost of Debt (Discount Rate) 2 years $62,100 $1,099 3.0% $600 10.0% of Purch. 20% 4 years 8.20% 30% 5.74% = End of year End of year 3 a 4 a PV of Avoided Costs Borrowed Funds Inflow Purchase Price Tax Rate Today $70,000 62,100 (62,100) 30% 30% 30% 30% 30% 30% Question 1 Part C (A) Leasing Option $65,100 Four Equal Annual Payments of $16,275 in Arrears Tax Rate After-tax Cost of Debt (Discount Rate) 30% 5.74% Today 1 End of year End of year a 1 PV of Avoided Costs Tax Rate $70,000 30% 30% 30% 30% Lease Payment ($16,275) ($16,275) ($16,275) ($16,275) NPV of Leasing Option $0 (B) Purchase Option Depreciable Life (Straight Line) Purchase Price Initial Annual Maintenance Maintenance Escalator In-House Maint. Costs Salvage Value Capital Gains Tax Debt Amortization Pre-tax Cost of Debt Income Tax Rate After-tax Cost of Debt (Discount Rate) ??? 2 years $62,100 $1,099 3.0% $600 of Purch. 20% 4 years 8.20% 30% 5.74% End of year End of year Today $70,000 62,100 (62,100) PV of Avoided Costs Borrowed Funds Inflow Purchase Price Tax Rate b C 30% 30% 30% 30% 30% 30% 30% 30% NPV of Purchase Option Memo: Debt Balance $62, 100 Lease $0 Buy NPVs SO Therefore, choose: Buy