Sadik Industries must install $1 million of new machinery in its Texas plant. It
ID: 2775573 • Letter: S
Question
Sadik Industries must install $1 million of new machinery in its Texas plant. It can obtain a bank loan for 100% of the required amount. Alternatively, a Texas investment banking firm that represents a group of investors believes it can arrange for a lease financing plan. Assume that the following facts apply:
The equipment falls in the MACRS 3-year class.
Estimated maintenance expenses are $50,000 per year.
The firm’s tax rate is 34%.
If the money is borrowed, the bank loan will be at a rate of 14%, amortized in six equal installments at the end of each year.
The tentative lease terms call for payments of $280,000 at the end of each year for 3 years. The lease is a guideline lease.
Under the proposed lease terms, the lessee must pay for insurance, property taxes, and maintenance.
Sadik must use the equipment if it is to continue in business, so it will almost certainly want to acquire the property at the end of the lease. If it does, than under the lease terms it can purchase the machinery at its fair market value at year 3. The best estimate of this marker value is $200,000, but it could be much higher or lower under certain circumstances. If purchased at year 3, the used equipment would fall into the MACRS 3-year class. Sadik would actually be able to make the purchase on the last day of the year (i.e., slightly before year 3), so Sadik would get to take the first depreciation expense at year 3 (the remaining depreciation expenses would be at year 4 through year 6). On the time line, Sadik would show the cost of the used equipment at year 3 and its depreciation expenses starting at year 3.
To assist management in making the proper lease versus buy decision, you are asked to answer the following questions:
What is the net advantage of leasing? Should Sadik take the lease?
Consider the $200,000 estimated residual value. How high could the residual value get before the net advantage of leasing falls to zero?
The decision almost can be considered a bet on the future residual value. Do you think the residual cash flows are equal in risk to the other cash flows? If not, how might you address this issue? (Hint: if you discount a negative cash flow at a higher rate, you get a better NPV-the NPV of a negative cash flow stream is less negative at high discount rates.)
Explanation / Answer
Loan Amount = 1,000,000
Interest Rate = 9.24%
Repayment = 14%
Cost of Capital - ($430,731.48)
Tax rate = 34%
Depreciation
Year 1
33%
Year 2
45%
Year 3
15%
Loan Amortization Schedule:
Year
Opening Amt (in $)
Instalment (in $)
Interest (in $)
Repayment (in $)
Ending Amt (in $)
1
1,000,000
430,731
140,000
290,731
709,269
2
709,269
430,731
99,298
331,434
377,835
3
377,835
430,731
52,897
377,835
Nil
Cost of Borrowing and owning:
Year 1:
Loan Payment - $430,731.48
Interest - $140,000
Tax savings on interest - $47,600
Depreciation - 333,300
Tax savings on depreciation = 113,322
Net cash Flow = 269,809.48
Year 2:
Loan Payment - $430,731.48
Interest - $99,298
Tax savings on interest - $33,761.18
Depreciation - 444,500
Tax savings on depreciation = 151,130
Net cash Flow = 245,840.30
Year 3:
Loan Payment - $430,731.48
Interest - $52,897
Tax savings on interest - $17,984.93
Depreciation - 148,100
Tax savings on depreciation 50,354
Net cash Flow 362,392,55
Present Value Cost of Owning = $730,991.68
COST OF LEASING:
Year 1:
Lease payment - 320,000
Tax savings after lease payment= 108,800
Current Value of Machine =Nil
Net cash flow - 211,200
Year 2:
Lease payment - 320,000
Tax savings after lease payment 108,800
Current Value of Machine Nil
Net cash flow - 211,200
Year 1:
Lease payment - 320,000
Tax savings after lease payment =108,800
Current Value of Machine 200,000
Net cash flow - 411,200
Present Value of Leasing = $685,752.02
Therefore,
The Present Value of the machinery after the leasing period is low.
Hence, the machine can be leased.
Depreciation
Year 1
33%
Year 2
45%
Year 3
15%
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