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 $94,000 for five years, due at the beginning of each year. This machine will save Farmer $36,000 per year through reductions in electricity costs. As an alternative, Farmer can purchase a more energy-efficient machine from Basic Machine Corporation (BMC) for $435,000. This machine will save $39,000 per year in electricity costs. A local bank has offered to finance the machine with a $435,000 loan. The interest rate on the loan will be 8 percent on the remaining balance and will require five annual principal payments of $87,000. Farmer has a target debt-to-asset ratio of 57 percent and a tax rate of 24 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

ii) The reduction in a company's ability to borrow because it leases its assets is known as debt displacement. Currently, provided the company can borrow $435000, leasing of machinery will reduce the company's capacity to borrow to that extend.

The present Value of lease payments is equal to $419,127. (94000*4.4588)

Reduction in borrowing capacity = 435,000-419,127 = $15,873

Therefore, the company can borrow only $15,873 more to maintain a target debt to assets ratio of 57%.