INSTRUCTIONS

1. This assignment is worth 10 points. 2. It is due 11:59pm, Apr 24, Thursday. You can have a 1-day grace period with an upfront loss of 2 points. Submission later than 11:59 pm, Apr 25 will not be accepted. 3. Use Excel functions, formulas and cell reference to fill in the colored cells to complete the work. 4. After completing the work, upload the Excel file to Blackboard.

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Chapter: Problem:

19 6

As part of its overall plant modernization and cost reduction program, Western Fabrics' management has decided to instal automated weaving loom. In the capital budgeting analysis of this equipment, the IRR of the project was found to be 20% project's required return of 12%.

The loom has an invoice price of $250,000, including delivery and installation charges. The funds needed could be borrow the bank through a 4-year amortized loan at a 10% interest rate, with payments to be made at the end of each year. In the e the loom is purchased, the manufacturer will contract to maintain and service it for a fee of $20,000 per year paid at the end year. The loom falls in the MACRS 5-year class, and Western's marginal federal-plus-state tax rate is 40%.

Gardial Automation Inc., maker of the loom, has offered to lease the loom to Westen for $70,000 upon delivery and installat plus 4 additional annual lease payments of $70,000 to be made at the ends of Years 1 through 4. (Note that there are 5 leas payments in total.) The lease agreement includes maintenance and servicing. Actually, the loom has an expected life of ei at which time its expected salvage value is zero; however, after 4 years, its market value is expected to equal its book value $42,500. Tanner-Woods plans to build and entirely new plant in 4 years, so it has no interest in either leasing or owning th loom for more than that period. a. Should the loom be leased or purchased? First, we want to lay out all of the input data in the problem. INPUT DATA Invoice Price Length of loan Loan Interest rate Maintenance fee Tax Rate Lease fee Equipment expected life Expected salvage value Market value after 4 years Book value after 4 years $250,000 4 10% $20,000 40% $70,000 8 $0 $42,500 $42,500

First, we can determine the annual loan payment that must be made on the new equipment. We will do so using the function wizard for PMT. Annual loan payment = Year Beginning loan balance Interest payment Principal payment Ending loan balance $78,868 1 $250,000 $25,000 $53,868 $196,132 2 $196,132 $19,613 $59,254 $136,878 3 $136,878 $13,688 $65,180 $71,698 4 $71,698 $7,170 $71,698 $0

A B C D E F G 53 Now, we see that the decision being made is whether to purchase the equipment at a net cost of $250,000 (with annual pay 54 $78,868) or lease the equipment and make annual payments of $70,000. To make this decision, we must analyze the increm 55 flows. 56

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Before proceeding with our NPV analysis we must determine the schedule of depreciation charges for this new equipment MACRS 5-year Depreciation Schedule Year 1 2 Depr. Rate 20.00% 32.00% Depr. Exp. $50,000 $80,000

3 19.20% $48,000

4 11.52% $28,800

5 11.52% $28,800

6 5.76% $14,400

We can now construct our table of incremental cash flows from these two alternatives. Remember, that the appropriate di in this scenario is the after tax cost of borrowing, or: 10%*(1-40%) = 6%. 0.06 NPV LEASE ANALYSIS OF INCREMENTAL CASH FLOWS Year = Cost of ownership Purchase cost Loan proceeds After-tax interest payment Principal payment Maintenance cost Tax savings from maintenance cost Tax savings from depreciation Salvage value Net cash flow from ownership PV cost of ownership Cost of leasing Lease payment Tax savings from lease payment Net cash flow from leasing PV cost of leasing Cost Comparison PV ownership cost @ 6% PV of leasing @ 6% Net Advantage to Leasing 0 ($250,000) $250,000 ($15,000) ($53,868) ($20,000) $8,000 $20,000 $0 ($185,323.87) ($60,868) ($11,768) ($59,254) ($20,000) $8,000 $32,000 ($51,022) ($8,213) ($65,180) ($20,000) $8,000 $19,200 ($66,193) 1 2 3

($70,000) $28,000 ($42,000) ($187,534.44)

($70,000) $28,000 ($42,000)

($70,000) $28,000 ($42,000)

($70,000) $28,000 ($42,000)

($185,324) ($187,534) ($2,211)

What is your suggestion, owning or leasing? Owning since NAL is negative

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b. The salvage value is clearly the most uncertain cash flow in the analysis. Assume that the appropriate salvage value p discount rate is 15 percent. What would be the effect of a salvage value risk adjustment on the decision?

All cash flows would remain unchanged except that of the salvage value. Our new array of cash flows would resemble the following: Standard discount rate Salvage value rate Year = Net cash flow PV of net cash flows NPV of ownership New Cost Comparison PV ownership cost @ 6% PV of leasing @ 6% Net Advantage to Leasing Now what do you say? Buying since NAL is positive 10% 15% 0 $0 $0 ($188,880) 0.06 0.09 1 ($60,868) ($57,422) 2 ($51,022) ($45,410) 3 ($66,193) ($55,577) Operating cash 4 ($76,480) ($60,579)

($188,880) ($187,534) $1,345

c. Assuming that the after-tax cost of debt should be used to discount all anticipated cash flows, at what lease payment w firm be indifferent to either leasing or buying? Hint: Use the Goal Seek function to determine the lease payment that makes the Net Advantage to Leasing zero. Crossover = $70,502 Used what if analysis - set C117, to value 0, by changing C36

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3 4 5 anagement 6 has decided to install a new he project7 was found to be 20% versus the 8 9 10 e funds needed could be borrowed from 11 at the end of each year. In the event that 12 f $20,000 13 per year paid at the end of each 14 tax rate is 40%. 15 16 17delivery and installation (at t=0) 0,000 upon 18 ugh 4. (Note that there are 5 lease 19 e loom has an expected life of eight years, 20 expected to equal its book value of 21 est in either leasing or owning the proposed 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 t. We will 42 do so using the 43 44 45 46 47 48 49 50 51 52

H I cost of $250,000 (with annual payments of 53 sion, we must 54 analyze the incremental cash 55 56

H I 57 charges for this new equipment. 58 59 60 61 62 63 64 emember, 65 that the appropriate discount rate 66 67 68 69 70 4 71 72 73 74 ($4,301.87) 75 ($71,698) 76 ($20,000) 77 $8,000 78 $11,520 79 $42,500 80 ($33,980) 81 82 83 84 ($70,000) 85 $28,000 86 ($42,000) 87 88 89 90 91 92 93 94 95 96 97

H I 98 the appropriate salvage value pre-tax 99 n the decision? 100 101 f cash flows 102 would resemble the 103 104 105 106 107 Salvage value cash 108 4 109 $42,500 110 $30,108 111 112 113 114 115 116 117 118 119 120 121 122 sh flows, 123 at what lease payment would the 124 125 ntage to Leasing 126 zero. 127 by changing 128C36 129 130 131 132 133 134 135

loan amount term in mos interest rate payment

100,000 180 7.0%

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