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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 ANALYSIS As part of its overall plant modernization and cost reduction program, the management of Tanner-Woods Textile Mills has decided to install a new automated weaving loom. In the capital budgeting analysis of this equipment, the IRR of the project was 20% versus a project required return of 12%.

The loom has an invoice price of $250,000, including delivery and installation charges. The funds needed could be borrowed from the bank through a 4-year amortized loan at a 10% interest rate, with payments to be made at year-end. In the event the loom is purchased, the manufacturer will contract to maintain and service it for a fee of $20,000 per year paid at year-end. The loom falls in the MACRS 5-year class, and Tanner-Woods's marginal federal-plus-state tax rate is 40%. The applicable MACRS rates are 20%. 32%, 19%, 12%, 11%, and 6%.

United Automation Inc., maker of the loom, has offered to lease the loom to Tanner-Woods for $70,000 upon delivery and installation (at t = 0) plus 4 additional annual lease payments of $70,000 to be made at the end of Years 1 through 4. (Note that there are 5 lease payments in total.) The lease agreement includes maintenance and servicing. Actually, the loom has an expected life of 10 years, at which time its expected salvage value is zero; however, after 4 years, its market value is expected to equal its book value of $42,500. Tanner-Woods plans to build an entirely new plant in 4 years, so it has no interest in leasing or owning the proposed loom for more than that period.

  1. a. Should the loom be leased or purchased?
  2. b. The salvage value is clearly the most uncertain cash flow in the analysis. Assume that the appropriate salvage value pretax discount rate is 15%. What would be the effect of a salvage value risk adjustment on the decision?
  3. c. The original analysis assumed that Tanner-Woods would not need the loom after 4 years. Now assume that the firm will continue to use the loom after the lease expires. Thus, if it leased, Tanner-Woods would have to buy the asset after 4 years at the then existing market value, which is assumed to equal the book value. What effect would this requirement have on the basic analysis? (No numerical analysis is required; just verbalize.)

a.

Summary Introduction

To Determine: Whether Company TWTM should be lease or purchase the loom.

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 cost of debt

AftertaxCostofDebt=[CostofDebt×(1TaxRate)]=[10%×(140%)]=[10%×60%]=0.06or6%

Therefore the after-tax cost of debt is 6%

Determine the present value of cost of owing

Using an excel spreadsheet the present value of cost of owing is determined as -$185,111.59.

Excel Spreadsheet:

Excel Workings:

Therefore the present value of cost of owing is -$185,111.59.

Determine the present value of cost of leasing

Using an excel spreadsheet the present value of cost of leasing is determined as -$184,534

b.

Summary Introduction

To Determine: The effect of salvage value risk adjustment.

c.

Summary Introduction

To Determine: The effect if the company purchases the machine.

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