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 that it can arrange for a lease financing plan. Assume that these 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 37%.

If the money is borrowed, the bank loan will be at a rate of 15%, 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, then under the lease terms it can purchase the machinery at its fair market value at Year 3. The best estimate of this market 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.

Year 3-year MACRS

1 33.33 %

2 44.45 %

3 14.81 %

4 7.41 %

What is the net advantage of leasing? Should Sadik take the lease? Do not round intermediate calculations. Round your answer to the nearest dollar. Net advantage of leasing $

Answer 1

a)	PV COST OF OWNING:
	Discount rate = 15%*(1-0.37) =	9.45%
	Loan amortization:
	Annual installments due at the end of the year = 1000000*0.15*1.15^6/(1.15^6-1) =	$     2,64,237
	Amortization table:
		0	1	2	3	4	5	6
	Beginning loan balance		1000000	885763	754390	603312	429572	229771
	Interest at 15%		150000	132864	113159	90497	64436	34466
	Total		1150000	1018627	867549	693809	494008	264236
	Less: Installment payment		264237	264237	264237	264237	264237	264236
	Ending loan balance		885763	754390	603312	429572	229771	0
	After tax interest (Interest*0.63)		94500	83705	71290	57013	40595	21713
	Repayment of principal		114237	131373	151078	173740	199801	229770	1000000
	Depreciation:
	Depreciation rate		0.3333	0.4445	0.1481	0.0741
	Depreciation on 1000000		333300	444500	148100	74100			1000000
	The PV of owning is calculated in the table below:
	Principal repayment		-114237	-131373	-151078	-173740	-199801	-229770	-1000000
	After tax interest		-94500	-83705	-71290	-57013	-40595	-21713
	Tax shield on depreciation at 37%		123321	164465	54797	27417	0	0
	Net cash flows		-85416	-50612	-167571	-203336	-240396	-251484
	PVIF at 9.45%	1	0.91366	0.83477	0.76270	0.69685	0.63668	0.58171
	PV at 9.45%		-78041	-42250	-127806	-141694	-153055	-146290	-689137
	PV OF OWNING	$   -6,89,137
b)	PV OF LEASING:
	After tax lease payments = 280000*(1-0.37) =		-176400	-176400	-176400
	Purchase cost				-200000
	Depreciation on second hand machinery				66660	88900	29620	14820	200000
	Tax shield on depreciation at 37%				24664	32893	10959	5483
	Net cash flows of lease		-176400	-176400	-351736	32893	10959	5483
	PVIF at 9.45%	1	0.91366	0.83477	0.76270	0.69685	0.63668	0.58171
	PV at 9.45%		-161169	-147254	-268268	22921	6978	3190	-543603
c)	NET ADVANTAGE OF LEASING:
	PV of leasing	$   -5,43,603
	Less: PV of owning	$   -6,89,137
	NET ADVANTAGE OF LEASING:	$     1,45,534
	NOTE:
	Insurance, property taxes and maintenance are payable under both options; hence excluded.