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Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

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. 1. The equipment falls in the MACKS 3-year class. The applicable MACRS rates are 33%, 45%. 15%, and 7%.
  2. 2. Estimated maintenance expenses are $80,000 per year.
  3. 3. Sullivan-Swift's federal-plus-state tax rate is 45%.
  4. 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. 5. The tentative lease terms call for end-of-year payments of $300,000 per year for 4 years.
  6. 6. Under the proposed lease terms, the lessee must pay for insurance, property taxes, and maintenance.
  7. 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.

  1. a. Assuming that the lease can be arranged, should Sullivan-Swift lease or borrow and buy the equipment? Explain.
  2. b. Consider the $300,OCX) 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.

a.

Summary Introduction

To Determine: Whether Company SSM can lease or borrow to buy the equipment by supposing that the lease can be organized.

Introduction: A lease is characterized as an agreement between a lessee and a lessor for the contract of a particular asset for a particular period on payment of determined rents.

Explanation

Determine the after-tax interest rate

AftertaxInterestRate=[BankRate×(1TaxRate)]=[13%×(145%)]=0.0715or7.15%

Therefore the after-tax interest rate is 7.15%

Determine the present value of cost of owing

Using an excel spreadsheet the present value of cost of owing is determined as $602,345.86. The maintenance cost is not considered in the calculation because the company has to pay the maintenance cost for the machinery when it buys or leases the machinery.

Excel Spreadsheet:

Excel Workings:

Therefore the present value of cost of owing is $602.345.86.

Determine the present value of cost of leasing

Using an excel spreadsheet the present value of cost of leasing is determined as $557,002

b.

Summary Introduction

To Discuss: 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.

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