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7/3/2003

Chapter 20. Ch 20-06 Build a Model

As part of its overall plant modernization and cost reduction program, Western Fabrics' management has decided to install
a new automated weaving loom. In the capital budgeting analysis of this equipment, the IRR of the project was found to be
20% versus a project required return of 12%.
The loom has an invoice price of $250,000, including delivery and installation charges. The funds needed could be
borrowed from 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 event that 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 of each year. The loom falls in the MACRS 5-year class, and Western's marginal federalplus-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
installation (at t=0) 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 lease payments in total.) The lease agreement includes maintenance and servicing. Actually, the loom has
an expected life of eight years, at which time its expected salvage value is zero; however, after 4 years, its market value is
expected to equal its book value of $42,500. Tanner-Woods plans to build and entirely new plant in 4 years, so it has no
interest in either leasing or owning the proposed 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 =

$78,868

Year
Beginning loan balance
Interest payment
Principal payment
Ending loan balance

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

Now, we see that the decision being made is whether to purchase the equipment at a net cost of $250,000 (with annual
payments of $78,868) or lease the equipment and make annual payments of $70,000. To make this decision, we must
analyze the incremental cash flows.

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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%
32%
Depr. Exp.
$50,000
$80,000

3
19%
$47,500

4
12%
$30,000

5
11%
$27,500

6
6%
$15,000

We can now construct our table of incremental cash flows from these two alternatives. Remember, that the appropriate
discount rate in this scenario is the after tax cost of borrowing, or: 10%*(1-40%) = 6%.
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

($250,000)
$250,000
($15,000)
($53,868)
($20,000)
$8,000
$20,000

($11,768)
($59,254)
($20,000)
$8,000
$32,000

($8,213)
($65,180)
($20,000)
$8,000
$19,000

$0
($185,112)

($60,868)

($51,022)

($66,393)

($4,302)
($71,698)
($20,000)
$8,000
$12,000
$42,500
($33,500)

($70,000)
$28,000
($42,000)
($187,534)

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

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

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

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

($185,112)
($187,534)
($2,423)

Our NPV Analysis has told us that there is a negative advantage to leasing. We interpret that as an indication that the firm
should forego the opportunity to lease and buy the new equipment.

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b. The salvage value is clearly the most uncertain cash flow in the analysis. Assume that the appropriate salvage value
pre-tax 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

10%
15%
0
$0
$0

NPV of ownership

($188,667)

New Cost Comparison

PV ownership cost @ 6%
PV of leasing @ 6%
Net Advantage to Leasing

($188,667)
($187,534)
$1,133

1
($60,868)
($57,422)

2
($51,022)
($45,410)

3
($66,393)
($55,744)

4
($76,000)
($60,199)

4
$42,500
$30,108

Under this new assumption of using a greater discount factor for the salvage value, we find that the firm should lease, and
not buy, the equipment.
c. Assuming that the after-tax cost of debt should be used to discount all anticipated cash flows, at what lease payment
would the firm be indifferent to either leasing or buying?
We will use the Goal Seek function to determine the lease payment that makes the Net Advantage to Leasing zero.
Crossover =

69,096