Big Sky Mining Company must install $1.5 million of new machinery in its Nevada
ID: 2750881 • Letter: B
Question
Big Sky Mining Company must install $1.5 million of new machinery in its Nevada mine. It can obtain a bank loan for 100% of the purchase price, or it can lease the machinery. Assume that the following facts apply:
The machinery falls into the MACRS 2-year class.
Under either the lease or the purchase, Big Sky must pay for insurance, property taxes, and maintenance.
The firm’s tax rate is 40%.
The loan would have an interest rate of 15%.
The lease terms call for $400,000 payments at the end of each of the next 4 years.
Assume that Big Sky Mining has no use for the machine beyond the expiation of the lease, the machine has an estimated residual value of $250,000 at the end of the 4th year.
What is the NAL of the lease? Answer by competing the following worksheet template. (Please refer to the lecture notes).
Please show all work and formulas.
NPV LEASE ANALYSIS Year 0 1 2 3 4 After-tax cash flows from leasing (Leasing) Lease payment ($400,000) ($400,000) ($400,000) ($400,000) ($400,000) Tax savings from lease $160,000 $160,000 $160,000 $160,000 $160,000 Net cash flow ($240,000) ($240,000) ($240,000) ($240,000) ($240,000) PV cost of leasing at 9% <--(1-40%)*15% ($1,017,532.77) After-tax cash flows from buying the asset (Borrowing & Buying) Payment of principal Interest Tax savings from interest Tax Savings from depreciation Sales Price Tax on gain/loss Net cash flow PV cost of owning at 9% <--(1-40%)*15% NPV criterion: NAL=PV cost of leasing-PV cost of buying Decision?? Lease or Buy MACRS rates 33% 45% 15% 7%Explanation / Answer
NPV LEASE ANALYSIS Year 0 1 2 3 4 After cash flows from lease Lease payment 400000 400000 400000 400000 Tax savings from lease 160000 160000 160000 160000 Net Cash Flow 240000 240000 240000 240000 Total PV of cost of leasing at 9% (15*1-0.4)= 240000*3.240 777600 After tax cash flows from buying the asset Payment of Principal 300394 345453 397271 456882 Interest 225000 179941 128123 68532 Tax shield on interest @ 40% -90000 -71976 -51249 -27413 Tax shield on depreciation @ 40% -198000 -270000 -90000 -42000 Sales Price -250000 Tax on gain @ 40% 100000 Net Cash flow 237394 183418 384145 306001 PVIF @ 9% 0.917 0.842 0.772 0.708 PV 217690 154438 296560 216649 Total PV of cash flows from buying 885337 (Cash outflows are shown as positive and inflows are shown as negative) NPV criterion NAL = PV of cost of leasing - Pv of cost of buying = 777600 - 885337 = -107737 Decision: Since the PV of outflows due to leasing is less by $ 107,737, the Leasing alternative is selected. Working Notes: Equated annual instalment for repaying the loan with interest @ 15% in four years (it is presumed that the repayment of the loan is such. The problem is silent on this aspect) Loan amount /PVIFA(15,4) = 1500000/2.855=525394 Loan - opening balance 1500000 1199606 854153 456882 Add: Interest for the year @ 15% 225000 179941 128123 68532 Total with interest 1725000 1379547 982276 525414 Less: payment of instalment 525394 525394 525394 525414 Loan - closing balance 1199606 854153 456882 0 Break up of interest & principal repayment from the equated instalment Interest 225000 179941 128123 68532 Principal repayment 300394 345453 397271 456882 Depreciation MARCS rate % 33 45 15 7 Depreciation 495000 675000 225000 105000 Cumulative Depreciation 495000 1170000 1395000 1500000
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