Smith company is conducting a lease analysis on some assembly line equipment tha
ID: 2615101 • Letter: S
Question
Smith company is conducting a lease analysis on some assembly line equipment that it will procure in the coming year. The following data have been developed.
• Smith plans to acquire an automated assembly line with a 10-year life and a cost of $10 million, delivered and installed. However, Smith plans to use the equipment for only 5 years, for it will discontinue the product line at that time. • Smith can borrow the required $10 million at an after-tax cost of 10%.
• The equipment’s estimated salvage value is $50,000 after 10 years of use, but it is $1,000,000 after only 5 years of use.
• Smith can lease the equipment for 5 years at a rental charge of $2,750,000, payable at the beginning of each year, but the lessor will own the equipment upon the expiration of the lease.
• Depreciation rate is 0.2, 0.32, 0.19, 0.12 and 0.11 in years 1 through 5, respectively. • Smith’s corporate tax rate is 40%. Should Smith lease or borrow and buy the equipment?
Borrowing and buying (price in thousand $)
Year
0
1
2
3
4
5
1
purchase price
-10,000
2
dep tax savings
800
1,280
760
480
440
3
Salvage
1,000
4
Tax payable on sale
-160
5
Net cash flows
-10,000
800
1,280
760
480
1280
Cost of debt
0.10
PV
-10,000
727
1,058
571
328
795
NPV of borrow to buy
-$6,521.25
in this answer, i want to now how to caclulate the salvage is 1000 and
why the purchase price is -10000
Borrowing and buying (price in thousand $)
Year
0
1
2
3
4
5
1
purchase price
-10,000
2
dep tax savings
800
1,280
760
480
440
3
Salvage
1,000
4
Tax payable on sale
-160
5
Net cash flows
-10,000
800
1,280
760
480
1280
Cost of debt
0.10
PV
-10,000
727
1,058
571
328
795
NPV of borrow to buy
-$6,521.25
Explanation / Answer
Cost of automated assembly line given in the question = $10 million
= $10,000,000
When investment is made in a project, there is a cash outflow. Hence the purchase price is shown in negative. All figures given in the solution are in thousand $.
Hence, purchase price = $10,000,000
= $10,000 thousand
Since there is an evaluation of lease or borrow and buy the project for 5 years, hence salvage value of the project after 5 years has been considered in the solution which is given as $1,000,000.
Salvage value after 5 years = $1,000,000
= $1,000 thousand
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