Sullivan-Swift Mining Company must install $1.2 million of newmachinery 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 investorsbelieves that it can arrange for a lease financing plan. Assume that the following factsapply:1. The equipment falls in the MACRS 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 equalinstallments 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 for4 years.6. Under the proposed lease terms, the lessee must pay for insurance, property taxes, andmaintenance.7. The equipment has an estimated salvage value of $300,000, which is the expectedmarket value after 4 years, at which time Sullivan-Swift plans to replace the equipmentregardless of whether the firm leases or purchases it. The best estimate forthe salvage value is $300,000, but it may be much higher or lower under certaincircumstances.To assist management in making the proper lease-versus-buy decision, you are asked toanswer the following questions.a. Assuming that the lease can be arranged, should Sullivan-Swift lease or borrow andbuy the equipment? Explain.b. Consider the $300,000 estimated salvage value. Is it appropriate to discount it at thesame rate as the other cash flows? What about the other cash flows—are they allequally risky? Explain.
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 MACRS 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 $300,000 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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