Trasky Company is trying to decide whether it should purchase or lease a new aut

Question

Trasky Company is trying to decide whether it should purchase or lease a new automated machine to be used in the production of a new product. If purchased, the new machine would cost $100,000 and would be used for ten years. The salvage value at the end of ten years is estimated at $20,000. The machine would be depreciated using MACRS over a seven year period. The annual maintenance and operating costs would be $20,000. Annual revenues are estimated at $55,000.

If the machine is leased, the company would need to pay annual lease payments of $20,700. The first lease payment and a deposit of $5,000 are due immediately. The last lease payment is paid at the beginning of Year 10. The deposit is refundable at the end of the tenth year. In additional, under a normal contract, the company must pay for all maintenance and operating costs, although the leasing company does offer a service contract that will provide annual maintenance (on leased machines only). The contract must be paid up front and costs $30,000. Trasky estimates that the contract will reduce its annual maintenance and operating costs by $10,000. Trasky’s cost of capital is 14%. The tax rate is 40%. The service contract’s costs would e expensed over the 10 year period. Assume this is an operating lease.

a.Calculate the NPV for the purchase, lease without the service contract, and the lease with the service contract.

b.Which is the best alternative?

If anybody can help, thanks!

Explanation / Answer

a.

NPV for the Purchase

37,280

b.

Thus, based on above analysis Lease with service is best alternative because of higher NPV.

Years 0 1 2 3 4 5 6 7 8 9 10 Total Cost of machine (100,000) Annual Revenue 55,000 55,000 55,000 55,000 55,000 55,000 55,000 55,000 55,000 55,000 550,000 Annual operting cost 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 200,000 Depreciation 14,286 14,286 14,286 14,286 14,286 14,286 14,286    100,000 Net profit before tax 20,714 20,714 20,714 20,714 20,714 20,714 20,714 35,000 35,000 35,000 250,000 tax 8,286 8,286 8,286 8,286 8,286 8,286 8,286 14,000 14,000 14,000 100,000 net profit after tax 12,429 12,429 12,429 12,429 12,429 12,429 12,429 21,000 21,000 21,000 150,000 Depreciation 14,286 14,286 14,286 14,286 14,286 14,286 14,286 -   -   -   100,000 net cash flow 26,714 26,714 26,714 26,714 26,714 26,714 26,714 21,000 21,000 21,000 250,000 Discount factor @ 14% 1 0.877 0.769 0.675 0.592 0.519 0.456 0.400 0.351 0.308 0.270 Present value (100,000) 23,434 20,556 18,031 15,817 13,875 12,171 10,676 7,362 6,458 5,665 34,043 Salvage value after tax 12000* 0.27 3237 Net present Value

37,280

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