Ch 18-06 Build a Model Solution

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1	Ch 18-06 Build a Model								03/07/2003
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3	Chapter 18. Ch 18-06 Build a Model
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6	As part of its overall plant modernization and cost reduction program, Western Fabrics' management has
7	decided to install a new automated weaving loom. In the capital budgeting analysis of this equipment, the IRR of the project
8	was found to be 20% versus a project required return of 12%.
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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%.
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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.
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23	a. Should the loom be leased or purchased?
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25	First, we want to lay out all of the input data in the problem.
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27	INPUT DATA
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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
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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.
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43	Annual loan payment =
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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
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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.
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57	Before proceeding with our NPV analysis we must determine the schedule of depreciation charges for this new
58	equipment.
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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
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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%.**
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68	NPV LEASE ANALYSIS OF INCREMENTAL CASH FLOWS
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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
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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
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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.
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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?
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100	All cash flows would remain unchanged except that of the salvage value. Our new array of cash flows would resemble the
101	following:
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103	Standard discount rate		10%
104	Salvage value rate		15%
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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
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110	NPV of ownership
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112	New Cost Comparison
113	PV ownership cost @ 6%		$0
114	PV of leasing @ 6%		$0
115	Net Advantage to Leasing
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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.
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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?
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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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IFM7 Chapter 18

Ch 18-06 Build a Model Solution

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