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IFM7 Chapter 18


Ch 18-06 Build a Model Solution

  A B C D E F G H I
1 Ch 18-06 Build a Model               03/07/2003
2                  
Chapter 18.  Ch 18-06 Build a Model
4                  
                 
As part of its overall plant modernization and cost reduction program, Western Fabrics' management has                
decided to install a new automated weaving loom.  In the capital budgeting analysis of this equipment, the IRR of the project                
was found to be 20% versus a project required return of 12%.                
                 
10  The loom has an invoice price of $250,000, including delivery and installation charges.  The funds needed could be                
11  borrowed from the bank through a 4-year amortized loan at a 10% interest rate, with payments to be made at the end of                
12  each year.  In the event that the loom is purchased, the manufacturer will contract to maintain and service it for a fee of                
13  $20,000 per year paid at the end of each year.  The loom falls in the MACRS 5-year class, and Western's marginal                
14  federal-plus-state tax rate is 40%.                
15                   
16  Gardial Automation Inc., maker of the loom, has offered to lease the loom to Westen for $70,000 upon delivery and                
17  installation (at t=0) plus 4 additional annual lease payments of $70,000 to be made at the ends of Years 1 through 4.  (Note                
18  that there are 5 lease payments in total.)  The lease agreement includes maintenance and servicing.  Actually, the loom                
19  has an expected life of eight years, at which time its expected salvage value is zero; however, after 4 years, its market                
20  value is expected to equal its book value of $42,500.  Tanner-Woods plans to build and entirely new plant in 4 years, so                
21  it has no interest in either leasing or owning the proposed loom for more than that period.                
22                   
23  a.   Should the loom be leased or purchased?                
24                   
25  First, we want to lay out all of the input data in the problem.                
26                   
27  INPUT DATA                
28                   
29  Invoice Price   $250,000            
30  Length of loan   4            
31  Loan Interest rate   10%            
32  Maintenance fee   $20,000            
33  Tax Rate   40%            
34  Lease fee   $70,000            
35  Equipment expected life   8            
36  Expected salvage value   $0            
37  Market value after 4 years   $42,500            
38  Book value after 4 years   $42,500            
39                   
40  First, we can determine the annual loan payment that must be made on the new equipment. We will do so using the                
41  function wizard for PMT.                
42                   
43  Annual loan payment  =                
44                   
45  Year   1 2 3 4      
46  Beginning loan balance   $250,000 $275,000 $302,500 $332,750      
47  Interest payment   $25,000 $27,500 $30,250 $33,275      
48  Principal payment   ($25,000) ($27,500) ($30,250) ($33,275)      
49  Ending loan balance   $275,000 $302,500 $332,750 $366,025      
50                   
51                   
52                   
53  Now, we see that the decision being made is whether to purchase the equipment at a net cost of $250,000 (with annual                
54  payments of $78,868) or lease the equipment and make annual payments of $70,000.  To make this decision, we must                
55  analyze the incremental cash flows.                
56                   
57  Before proceeding with our NPV analysis we must determine the schedule of depreciation charges for this new                
58  equipment.                
59                   
60  MACRS 5-year Depreciation Schedule                
61  Year 1 2 3 4 5 6    
62  Depr. Rate 20% 32% 19% 12% 11% 6%    
63  Depr. Exp. $50,000 $80,000 $47,500 $30,000 $27,500 $15,000    
64                   
65  We can now construct our table of incremental cash flows from these two alternatives.  Remember, that the appropriate                
66  discount rate in this scenario is the after tax cost of borrowing, or:  10%*(1-40%) = 6%.                
67                   
68  NPV LEASE ANALYSIS OF INCREMENTAL CASH FLOWS                
69                   
70    Year  =   0 1 2 3 4  
71     Cost of ownership                
72  Purchase cost     ($250,000)          
73  Loan proceeds     $250,000          
74  After-tax interest payment       ($15,000) ($16,500) ($18,150) ($19,965)  
75  Principal payment       $25,000 $27,500 $30,250 $33,275  
76  Maintenance cost       ($20,000) ($20,000) ($20,000) ($20,000)  
77  Tax savings from maintenance cost       $8,000 $8,000 $8,000 $8,000  
78  Tax savings from depreciation       $20,000 $32,000 $19,000 $12,000  
79  Salvage value             $42,500  
80  Net cash flow from ownership                
81  PV cost of ownership                
82                   
83     Cost of leasing                
84  Lease payment     ($70,000) ($70,000) ($70,000) ($70,000) ($70,000)  
85  Tax savings from lease payment     $28,000 $28,000 $28,000 $28,000 $28,000  
86  Net cash flow from leasing                
87  PV cost of leasing                
88                   
89     Cost Comparison                
90  PV ownership cost @ 6%   $0            
91  PV of leasing @ 6%   $0            
92  Net Advantage to Leasing                
93                   
94  Our NPV Analysis has told us that there is a negative advantage to leasing.  We interpret that as an indication that the                
95  firm should forego the opportunity to lease and buy the new equipment.                
96                   
97  b.   The salvage value is clearly the most uncertain cash flow in the analysis.  Assume that the appropriate salvage value                
98        pre-tax discount rate is 15 percent.  What would be the effect of a salvage value risk adjustment on the decision?                
99                   
100  All cash flows would remain unchanged except that of the salvage value.  Our new array of cash flows would resemble the                
101  following:                
102                   
103  Standard discount rate   10%            
104  Salvage value rate   15%            
105                   
106  Year    =   0 1 2 3 4 4  
107  Net cash flow   $0 $0 $0 $0 $13,310 $42,500  
108  PV of net cash flows   $0 $0 $0 $0 $10,543 $30,108  
109                   
110  NPV of ownership                
111                   
112     New Cost Comparison                
113  PV ownership cost @ 6%   $0            
114  PV of leasing @ 6%   $0            
115  Net Advantage to Leasing                
116                   
117  Under this new assumption of using a greater discount factor for the salvage value, we find that the firm should lease, and                
118  not buy, the equipment.                
119                   
120  c.   Assuming that the after-tax cost of debt should be used  to discount all anticipated cash flows, at what lease payment                
121        would the firm be indifferent to either leasing or buying?                
122                   
123  We will use the Goal Seek function to determine the lease payment that makes the Net Advantage to Leasing zero.                
124                   
125  Crossover  =                
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