High electricity costs have made Farmer Corporation’s chicken-plucking machine e

Question

High electricity costs have made Farmer Corporation’s chicken-plucking machine economically worthless. Only two machines are available to replace it. The International Plucking Machine (IPM) model is available only on a lease basis. The lease payments will be $79,000 for five years, due at the beginning of each year. This machine will save Farmer $29,000 per year through reductions in electricity costs. As an alternative, Farmer can purchase a more energy-efficient machine from Basic Machine Corporation (BMC) for $400,000. This machine will save $39,000 per year in electricity costs. A local bank has offered to finance the machine with a $400,000 loan. The interest rate on the loan will be 9 percent on the remaining balance and will require five annual principal payments of $80,000. Farmer has a target debt-to-asset ratio of 65 percent. Farmer is in the 34 percent tax bracket. After five years, both machines will be worthless. The machines will be depreciated on a straight-line basis.

A. What is the NAL of leasing? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

     NAL =

B. How much debt is displaced by this lease? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

     PV =

High electricity costs have made Farmer Corporation’s chicken-plucking machine economically worthless. Only two machines are available to replace it. The International Plucking Machine (IPM) model is available only on a lease basis. The lease payments will be $79,000 for five years, due at the beginning of each year. This machine will save Farmer $29,000 per year through reductions in electricity costs. As an alternative, Farmer can purchase a more energy-efficient machine from Basic Machine Corporation (BMC) for $400,000. This machine will save $39,000 per year in electricity costs. A local bank has offered to finance the machine with a $400,000 loan. The interest rate on the loan will be 9 percent on the remaining balance and will require five annual principal payments of $80,000. Farmer has a target debt-to-asset ratio of 65 percent. Farmer is in the 34 percent tax bracket. After five years, both machines will be worthless. The machines will be depreciated on a straight-line basis.

Explanation / Answer

Assumptions Lease Annual payments $2,100 Term of lease and useful life 5 years Annual electricity cost savings $6,000 Purchase Cost $15,000 Useful life 5 years Annual electricity cost savings $9,000 Interest rate on loan 10% Term of loan 5 years Target debt-to-asset ratio 67% Firm's tax rate 34% a. Should Farmer lease the IPM machine or purchase the more efficient BMC machine? Cash flow from leasing 0 1 2 3 4 5 After tax savings $3,960 $3,960 $3,960 $3,960 $3,960 Lease payment (2,100) (2,100) (2,100) (2,100) (2,100) Tax benefit of lease payments 714 714 714 714 714 Net cash flows $2,574 $2,574 $2,574 $2,574 $2,574 Cash flow from purchasing 0 1 2 3 4 5 After tax savings $5,940 $5,940 $5,940 $5,940 $5,940 Purchase ($15,000) Depreciation tax savings 1,020 1,020 1,020 1,020 1,020 Net cash flows ($15,000) $6,960 $6,960 $6,960 $6,960 $6,960 Incremental cash flows from leasing versus purchasing 0 1 2 3 4 5 Lease $2,574 $2,574 $2,574 $2,574 $2,574 Purchase ($15,000) $6,960 $6,960 $6,960 $6,960 $6,960 ($15,000) ($4,386) ($4,386) ($4,386) ($4,386) ($4,386) Present value of purchase $15,000 Present value of leasing $18,178 A. Net Advantage of Leasing $3,177.72 c. How much debt is displaced by this lease? The amount of displaced debt is the PV of the incremental cash flows from year one through five. PV $16,626.39

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