Round Table Rental Yards provides construction equipment, trailers, crutches, et
ID: 2716661 • Letter: R
Question
Round Table Rental Yards provides construction equipment, trailers, crutches, etc., on short-term rentals. Historically, Art, the owner, has purchased the items that he rents out, but his business has been expanding so rapidly that he is considering both straight leases and lease purchase arrangements. He has decided to use the procurement of a new bulldozer with a list price of $290,000 as a test case.
If he purchases the bulldozer outright, then he must also decide whether he should plan on overhauling it or selling it after 3 years. This overhaul will cost about $150,000, but it should double the useful life of the bulldozer. However, the bulldozer’s value on the used market would drop from $180,000 after Year 3 to $135,000 after Year 6. Its annual operation and maintenance costs will start at $25,000 and increase by $7500 each year. This increase is due to increased use more than to increased age, so it is not affected by the overhaul.
The manufacturer has a subsidiary that specializes in financing through leases and lease purchases. In both cases, the subsidiary uses a term of 5 years with no option to extend it further. Art believes that other contract periods could be negotiated, but for this initial analysis he believes that their standard term is representative of the other possibilities. For the standard lease, the annual payment is $45,000. For the lease-purchase, the annual payment increases by $42,000. Although lease contracts can be written either way, for this lease Art would be responsible for the overhaul cost at Year 3. Art will insure the bulldozer for theft, catastrophic damage, and liability. This policy will cost him $9500 each year. He will spend about 5% of the rental income transporting it to and from job sites. On the plus side, he expects it to bring in $175,000 the first year. Rental income should increase by $30,000 each year until it hits a maximum utilization of $300,000 per year.
a. If secured loans are available for 9%, which financing plan do you recommend?
b. Art’s business can depreciate the bulldozer under a 5-year modified accelerated cost recovery system (MACRS depreciation schedule, with a combined state and federal tax rate of 41%. Do tax considerations change your recommendation?
Please help me solve this Engineering Economy Financial Case Study question.
Explanation / Answer
Description Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Total Rental Income - a $175,000.00 $205,000.00 $235,000.00 $265,000.00 $295,000.00 $300,000.00 Transport Cost - b $8,750.00 $10,250.00 $11,750.00 $13,250.00 $14,750.00 $15,000.00 Insurance Cost - c $9,500.00 $9,500.00 $9,500.00 $9,500.00 $9,500.00 $9,500.00 Gross Inflow In all the three cases (d=a-b-c) $156,750.00 $185,250.00 $213,750.00 $242,250.00 $270,750.00 $275,500.00 Situation 1 A - Lease - Without Tax Lease Cost - e $45,000.00 $45,000.00 $45,000.00 $45,000.00 $45,000.00 Net Inflow (d-e) $111,750.00 $140,250.00 $168,750.00 $197,250.00 $225,750.00 PV @ 9% $102,522.94 $118,045.62 $130,305.96 $139,736.87 $146,722.01 $637,333.40 Situation 1 B - Lease - With Tax Lease Cost - e $45,000.00 $45,000.00 $45,000.00 $45,000.00 $45,000.00 Net Inflow (d-e) $57,522.94 $73,045.62 $85,305.96 $94,736.87 $101,722.01 Tax @ 41% $45,817.50 $57,502.50 $69,187.50 $80,872.50 $92,557.50 Net Inflow After tax $65,932.50 $82,747.50 $99,562.50 $116,377.50 $133,192.50 PV @ 9% $60,488.53 $69,646.92 $76,880.52 $82,444.76 $86,565.99 $376,026.71 Situation 2 A - Lease & Purchase - Without Tax Lease Cost - e $87,000.00 $87,000.00 $87,000.00 $87,000.00 $87,000.00 $0.00 Overhaul Cost $0.00 $0.00 $150,000.00 $0.00 $0.00 $0.00 Selling off Bulldozer - Inflow $0.00 $0.00 $0.00 $0.00 $0.00 $135,000.00 Net Inflow $69,750.00 $98,250.00 -$23,250.00 $155,250.00 $183,750.00 $410,500.00 PV @ 9% $63,990.83 $82,695.06 -$17,953.27 $109,983.01 $119,424.89 $244,767.74 $602,908.26 Situation 2 B - Lease & Purchase - With Tax Lease Cost - e $87,000.00 $87,000.00 $87,000.00 $87,000.00 $87,000.00 $0.00 Depreciation - f (Note 1) $0.00 $0.00 $0.00 $30,000.00 $48,000.00 $28,800.00 Net Income (d-e-f) $69,750.00 $98,250.00 $126,750.00 $125,250.00 $135,750.00 $246,700.00 Tax @ 41% $28,597.50 $40,282.50 $51,967.50 $51,352.50 $55,657.50 $101,147.00 Net Income After tax $41,152.50 $57,967.50 $74,782.50 $73,897.50 $80,092.50 $174,353.00 Add: Depreciation (non cash item) $0.00 $0.00 $0.00 $30,000.00 $48,000.00 $28,800.00 $41,152.50 $57,967.50 $74,782.50 $103,897.50 $128,092.50 $203,153.00 Inflow from Selling of Bulldozer ( Note 2) $0.00 $0.00 $0.00 $0.00 $0.00 $97,362.00 Net Inflow $41,152.50 $57,967.50 $74,782.50 $103,897.50 $128,092.50 $300,515.00 PV @ 9% $37,754.59 $48,790.09 $57,745.81 $73,603.61 $83,251.34 $179,187.28 $480,332.70 Situation 3 A - Purchase - Without Tax Purchase Cost $290,000.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 Overhaul Cost $0.00 $0.00 $0.00 $150,000.00 $0.00 $0.00 $0.00 Selling off Bulldozer - Inflow $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $135,000.00 Net Inflow -$290,000.00 $156,750.00 $185,250.00 $63,750.00 $242,250.00 $270,750.00 $410,500.00 PV @ 9% -$290,000.00 $143,807.34 $155,921.22 $49,226.70 $171,616.01 $175,968.92 $244,767.74 $651,307.92 Situation 3 B - Purchase - With Tax Depreciation (Note 3) $0.00 $58,000.00 $92,800.00 $55,680.00 $50,688.00 $50,688.00 $25,344.00 Net Profit after Depreciation $0.00 $98,750.00 $92,450.00 $158,070.00 $191,562.00 $220,062.00 $250,156.00 Less: Tax @ 41% $0.00 $40,487.50 $37,904.50 $64,808.70 $78,540.42 $90,225.42 $102,563.96 Net Profit after Tax $0.00 $58,262.50 $54,545.50 $93,261.30 $113,021.58 $129,836.58 $147,592.04 Add: Depreciation $0.00 $58,000.00 $92,800.00 $55,680.00 $50,688.00 $50,688.00 $25,344.00 Cash Inflow after adding Depreciation $0.00 $116,262.50 $147,345.50 $148,941.30 $163,709.58 $180,524.58 $172,936.04 Purchase Cost $290,000.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 Overhaul Cost $0.00 $0.00 $0.00 $150,000.00 $0.00 $0.00 $0.00 Selling off Bulldozer - Inflow $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $123,438.00 Net Cash Inflow -$290,000.00 $116,262.50 $147,345.50 -$1,058.70 $163,709.58 $180,524.58 $296,374.04 PV @ 9% -$290,000.00 $106,662.84 $124,017.76 -$817.51 $115,975.99 $117,328.59 $176,718.16 $349,885.83 Present Value Situation 1 A - Lease - Without Tax 637333.40 Situation 2 A - Lease & Purchase - Without Tax 602908.26 $651,307.92 Hence, in absence of Tax, Purchase is recommended as Present Value is maximum Situation 3 A - Purchase - Without Tax 651307.92 Situation 1 B - Lease - With Tax 376026.71 Situation 2 B - Lease & Purchase - With Tax 480332.70 $480,332.70 Hence, in case of Tax, Lease and Purchase is recommended as Present Value is maximum Situation 3 B - Purchase - With Tax 349885.83 Note 1 Since Overhaul cost is being incurred in the third year, depreciation can be claimed for lease and purchase Note 2 Book Value of Asset $43,200.00 Selling Price $135,000.00 Net Profit $91,800.00 Tax on above @41% $37,638.00 Net Inflow After tax $97,362.00 Note 3 - Depreciation Schedule Basis (MARCS Rate) Depreciation Basis - Overhaul Depreciation Total Dep Accu. Dep WDV of Asset Year 1 290000 20% 58000 0 0 58000 58000 232000 Year 2 290000 32% 92800 0 0 92800 150800 139200 Year 3 290000 19.20% 55680 0 0 55680 206480 83520 Year 4 290000 11.52% 33408 150000 17280 50688 257168 182832 Year 5 290000 12% 33408 150000 17280 50688 307856 132144 Year 6 290000 5.76% 16704 150000 8640 25344 333200 106800 Less: Selling Price 135000 Profit 28200 Tax on above 11562 Cash Inflow 123438 Note 4 Since lease is valid for 5 years, hence situation 1 can be appraised for 5 year tenure only.
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