High electricity costs have made Farmer Corporation’s chicken-plucking machine e
ID: 2776986 • Letter: H
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 $77,000 for five years, due at the beginning of each year. This machine will save Farmer $27,000 per year through reductions in electricity costs. As an alternative, Farmer can purchase a more energy-efficient machine from Basic Machine Corporation (BMC) for $390,000. This machine will save $37,000 per year in electricity costs. A local bank has offered to finance the machine with a $390,000 loan. The interest rate on the loan will be 11 percent on the remaining balance and will require five annual principal payments of $78,000. Farmer has a target debt-to-asset ratio of 68 percent. Farmer is in the 40 percent tax bracket. After five years, both machines will be worthless. The machines will be depreciated on a straight-line basis.
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))
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 $77,000 for five years, due at the beginning of each year. This machine will save Farmer $27,000 per year through reductions in electricity costs. As an alternative, Farmer can purchase a more energy-efficient machine from Basic Machine Corporation (BMC) for $390,000. This machine will save $37,000 per year in electricity costs. A local bank has offered to finance the machine with a $390,000 loan. The interest rate on the loan will be 11 percent on the remaining balance and will require five annual principal payments of $78,000. Farmer has a target debt-to-asset ratio of 68 percent. Farmer is in the 40 percent tax bracket. After five years, both machines will be worthless. The machines will be depreciated on a straight-line basis.
Explanation / Answer
Answer (a) Year 0 1 2 3 4 5 Cash flows asscoaited with Leasing -46200 -30000 -30000 -30000 -30000 16200 Discounted Cashflows at 0.1056 -46200.00 -30000.00 -30000.00 -30000.00 -30000.00 16200.00 Present Value of Leasing -150000 Cash flows associated with purchase -390000 70560 67128 63696 60264 56832 Discounted Cashflows at 0.1056 -390000.00 70560.00 67128.00 63696.00 60264.00 56832.00 Present Value of Purchase -71520 Net Advantage of Leasing 78480 (PV of Purchase - PV of Lease) Since NAL is positive it is advantageous to take machine on Lease After Tax Cost of Debt (11%*(1-0.4) = Disc Rate 0.066 Cash Flows Associated with Leasing Lease Payment -77000 -77000 -77000 -77000 -77000 Savings of Electricity Costs 27000 27000 27000 27000 27000 Net Cash Flows -77000 -50000 -50000 -50000 -50000 27000 Net After Tax Cash Flows(Tax 40%) -46200 -30000 -30000 -30000 -30000 16200 Cash Flows asscoaited with purchase Purchase Price -390000 Cost Savings 37000 37000 37000 37000 37000 Deprecitation (cost /5) 78000 78000 78000 78000 78000 Interest Payment 42900 34320 25740 17160 8580 Tax Shield on Depreciation + Interest 48360 44928 41496 38064 34632 After tax cost savings 22200 22200 22200 22200 22200 Net Cash Flows 70560 67128 63696 60264 56832 Cash flows associated with purchase -390000 70560 67128 63696 60264 56832 Calculation of Interest Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Loan -390000 -390000 -312000 -234000 -156000 -78000 Interest at 11% -42900 -34320 -25740 -17160 -8580 Loan Payment 78000 78000 78000 78000 78000 Balance Loan outstanding -390000 -312000 -234000 -156000 -78000 0 Answer(b) Target Debt Asset Ratio 68% Year 1 2 3 4 5 Net Cash flows of purchase alternative to lease 40560 37128 33696 30264 73032 After Tax cost of debt 0.066 Discounted Value 38048.7805 37128 33696 30264 73032 Total Discounted Value 212168.78 Total amount of debt displaced 144274.77 Total of Discounted flows to debt/asset ratio
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