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 $97,000 for five years, due at the beginning of each year. This machine will save Farmer $37,500 per year through reductions in electricity costs. As an alternative, Farmer can purchase a more energy-efficient machine from Basic Machine Corporation (BMC) for $450,000. This machine will save $40,500 per year in electricity costs. A local bank has offered to finance the machine with a $450,000 loan. The interest rate on the loan will be 9 percent on the remaining balance and will require five annual principal payments of $90,000. Farmer has a target debt-to-asset ratio of 54 percent and a tax rate of 22 percent. 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 answer to 2 decimal places, e.g., 32.16.)
b.	How much debt is displaced by this lease? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

    

Answer 1

a. NAL of leasing First Machine

Five payments of $ 97000 at the beginning of each year for five years

Rate = 9%

Cost of Machine taken on lease = 97000*5 = 485000

Net profit to farmer if machine taken on lease

Total of Lease Installments (97000*5)	485000
Less: Electricity saving (37500*5)	187500
Less: tax saving on Dep Calculation of Dep = 485000/5 = 97000 tax rate = 22% i.e. 21340 for 5 years = 21340*5 = 106700	106700
Net Cost of leasing	190800

NAL in case of purchase of machinery

Cost of MAchinery	450000
Interest on Machinery	121500
Less: Electricity savings for Five years 40500*5	202500
Less: tax Saving on Dep SLM method dep will be 90000 per year tax rate is 22% annual saving 90000*22% = 19800 per year for 5 year = 19800*5	99000
Net cost of purchase the machine	270000