LEASE VERSUS BUY Sullivan-Swift Mining Company must install $1.2 million of new machinery in its Nevada mine. It can obtain a bank loan for 100% of the required amount. Alternatively, a Nevada investment banking firm that represents a group of investors believes that it can arrange for a lease financing plan. Assume that the following facts apply: 1. The equipment falls in the MACKS 3-year class. The applicable MACRS rates are 33%, 45%. 15%, and 7%. 2. Estimated maintenance expenses are $80,000 per year. 3. Sullivan-Swift's federal-plus-state tax rate is 45%. 4. If the money is borrowed, the bank loan will be at a rate of 13%, amortized in 4 equal installments to be paid at the end of each year. 5. The tentative lease terms call for end-of-year payments of $300,000 per year for 4 years. 6. Under the proposed lease terms, the lessee must pay for insurance, property taxes, and maintenance. 7. The equipment has an estimated salvage value of $300,000, which is the expected market value after 4 years, at which time Sullivan-Swift plans to replace the equipment regardless of whether the firm leases or purchases it. The best estimate for the salvage value is $300,000, but it may be much higher or lower under certain circumstances. To assist management in making the proper lease-versus-buy decision, you are asked to answer the following questions. a. Assuming that the lease can be arranged, should Sullivan- Swift lease or borrow and buy the equipment? Explain. b. Consider the $300,0Cx) estimated salvage value. Is it appropriate to discount it at the same rate as the other cash flows? What about the other cash flows-are they all equally risky? Explain.
LEASE VERSUS BUY Sullivan-Swift Mining Company must install $1.2 million of new machinery in its Nevada mine. It can obtain a bank loan for 100% of the required amount. Alternatively, a Nevada investment banking firm that represents a group of investors believes that it can arrange for a lease financing plan. Assume that the following facts apply: 1. The equipment falls in the MACKS 3-year class. The applicable MACRS rates are 33%, 45%. 15%, and 7%. 2. Estimated maintenance expenses are $80,000 per year. 3. Sullivan-Swift's federal-plus-state tax rate is 45%. 4. If the money is borrowed, the bank loan will be at a rate of 13%, amortized in 4 equal installments to be paid at the end of each year. 5. The tentative lease terms call for end-of-year payments of $300,000 per year for 4 years. 6. Under the proposed lease terms, the lessee must pay for insurance, property taxes, and maintenance. 7. The equipment has an estimated salvage value of $300,000, which is the expected market value after 4 years, at which time Sullivan-Swift plans to replace the equipment regardless of whether the firm leases or purchases it. The best estimate for the salvage value is $300,000, but it may be much higher or lower under certain circumstances. To assist management in making the proper lease-versus-buy decision, you are asked to answer the following questions. a. Assuming that the lease can be arranged, should Sullivan- Swift lease or borrow and buy the equipment? Explain. b. Consider the $300,0Cx) estimated salvage value. Is it appropriate to discount it at the same rate as the other cash flows? What about the other cash flows-are they all equally risky? Explain.
Intermediate Financial Management (MindTap Course List)
13th Edition
ISBN:9781337395083
Author:Eugene F. Brigham, Phillip R. Daves
Publisher:Eugene F. Brigham, Phillip R. Daves
Chapter19: Lease Financing
Section: Chapter Questions
Problem 4P
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Good afternoon! I'm confused with the explanation in letter b, can you further explain why it's unsafe or why is it necessary to diminish the value? and why it's safe? Thank you so much for being responsive and I appreciate that. God bless
Transcribed Image Text:Explanation of Solution
The reasons on whether it is suitable to discount it at the similar
rate as the another cash flow and whether all the other cash flows
are equally risk is as follows:
It is assumed that Company SSM failed to design and keep utilizing
the equipment; as a result the salvage value of $300,000, inclusive
of taxes is considered as a positive cash flow in the expense of
owning investigation. It is discounted at 7.15%; however it is
unsafe, so it is necessary to utilize a greater discount rate.
Thusly, it is necessary to diminish the value of the inflow in the
most recent year in the expense of owning investigation, which
improves leasing seems to be effective. The cash flows for
acquiring and leasing, with the exception of the residual value of
cash flow, are generally sure on the grounds that they're fixed by
contract, and hence, are not exceptionally unsafe.
Transcribed Image Text:LEASE VERSUS BUY Sullivan-Swift Mining Company must install
$1.2 million of new machinery in its Nevada mine. It can obtain a
bank loan for 1009% of the required amount. Alternatively, a
Nevada investment banking firm that represents a group of
investors believes that it can arrange for a lease financing plan.
Assume that the following facts apply:
1. The equipment falls in the MACKS 3-year class. The
applicable MACRS rates are 33%, 45%. 15%, and 7%.
2. Estimated maintenance expenses are $80,000 per year.
3. Sullivan-Swift's federal-plus-state tax rate is 45%.
4. If the money is borrowed, the bank loan will be at a rate of
13%, amortized in 4 equal installments to be paid at the end
of each year.
5. The tentative lease terms call for end-of-year payments of
$300,000 per year for 4 years.
6. Under the proposed lease terms, the lessee must pay for
insurance, property taxes, and maintenance.
7. The equipment has an estimated salvage value of
$300,000, which is the expected market value after 4 years, at
which time Sullivan-Swift plans to replace the equipment
regardless of whether the firm leases or purchases it. The
best estimate for the salvage value is $300,000, but it may be
much higher or lower under certain circumstances.
To assist management in making the proper lease-versus-buy
decision, you are asked to answer the following questions.
a. Assuming that the lease can be arranged, should Sullivan-
Swift lease or borrow and buy the equipment? Explain.
b. Consider the $300,0Cx) estimated salvage value. Is it
appropriate to discount it at the same rate as the other cash
flows? What about the other cash flows-are they all equally
risky? Explain.
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