as part of its overall plant modernizatioon and cost reducation program, the man

Question

as part of its overall plant modernizatioon and cost reducation program, the managment of tanner-woods textile mills has decided to nstall anew automated weaving loom. in the capital budgeting analysis of this equipment, the IRR of the project was 15%. The loom has and invoice prices of $250,000 including delivery and installation charges. The funds needed could be borrowed from the bank through a 4 yar amortizeed loan at a 10% interest rate, with payments to be made at year-end. in the event the loom is purchased, the manufacturer will contract to maintain a nd wercie it for a fee of $22,000 per year paid at year-end. the loom fails in the MSCRS 5 year class, and Tanner-Woods marginal federal plus state tax rate is 40%. the applicable MACRS rates are 22%, 30%, 17%, 16%, and 5%. United Automation inc. maker of the loom, has offered to lease the loom to Tanner-woods for $70,000 upon delivery and installation (at t+0) plus 4 addditional annual lease payments of $70,000 to be made at the end of years 1 through 4. (note that there are 5 lease payments in total) The lease agreement includes maintenance serviceing. Acutally, the loom has an expected life of 10 years, at which time its expected salvage value is zero; howere, afer 4 years, its market value is expected to equal its book balue of $43,000. Tanner-woods plans to build an entirely new plant in 4 years, so it has no interest in leasing or woning the proposed loom for more than that period. a.) should the loom be purshced? pv cost of owning at 6% is $_______ PV cost of leasing at 6% is $______ b) the salvage value is clearly the most uncertain cash flow in the analysis, assume the appropriate saslvage value pretax discount rate is 15%. what wouled the effect of a salvage value risk adjustment on the decision? NPV is $_______?

Explanation / Answer

Ist Option Iind Option Dep Rate Loom Price $250000 Lease given 22% Loan 4 year period @10%, Installment at year End $70000 at begning 30% Fee 22000 at year end annually $70000 at 4 installment at year end 17% State Tax Rate 40% Loom Life 10 year 16% Lease given After 4 year value is 43000 5% Option I Purchase Out flow Year Purchae price Installment Interest Depreciation Maintainance Fee Tax Benefit On Int/Dep/Maint Net Out flow PV at 6% PV Out flow 0 250000 1 62500 25000 55000 22000 40800 68700 0.9 64811.32 2 62500 18750 75000 22000 46300 56950 0.9 50685.3 3 62500 12500 42500 22000 30800 66200 0.8 55582.8 4 62500 6250 40000 22000 27300 63450 0.8 50258.34 4Th year salvage (Assuming salvage is getting equal to Bookvalue) -37500 -37500 0.792094 -29703.5 PV of Out Flow 191634 Option II Leased Out flow Lease Rent Tax Benefit Net PV at 6% PV Out flow 0 70000 28000 42000 42000 1 70000 28000 42000 0.94 39622.64151 2 70000 28000 42000 0.89 37379.85048 3 70000 28000 42000 0.84 35264.00989 4 70000 28000 42000 0.79 33267.93386 PV of Out Flow 187534 Answer a) : Leased option is better as PV of Out flow in case of Purchase is higher from th present value of Leased out flow Option I Out flow At PV 15% Year Purchae price Installment Interest Depreciation Maintainance Fee Tax Benefit On Int/Dep/Maint Net Out flow PV at 15% PV Out flow 0 250000 1 62500 25000 55000 22000 40800 68700 0.87 59739.13 2 62500 18750 75000 22000 46300 56950 0.76 43062.38 3 62500 12500 42500 22000 30800 66200 0.66 43527.57 4 62500 6250 40000 22000 27300 63450 0.57 36277.74 4Th year salvage (Assuming salvage is getting equal to Bookvalue) -37500 -37500 0.57 -21440.7 PV of Out Flow 161166 Option II Leased Out flow PV 15% Lease Rent Tax Benefit Net PV at 15% PV Out flow 0 70000 28000 42000 42000 1 70000 28000 42000 0.87 36522 2 70000 28000 42000 0.76 31758 3 70000 28000 42000 0.66 27616 4 70000 28000 42000 0.57 24014 PV of Out Flow 161909 Answer B): If assumed Salvaged is equal to BV then Owned purchase option is is better as PV of Out flow in case of Purchase is lower from th present value of Leased out flow Answer B):If salvaged is nil or lesser its book value than Leased option is better as PV of Out flow in case of Purchase is higher from the present value of Leased out flow

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