Ch 20-06 Build a Model Solution								3/6/2001
Chapter 20. Solution to Ch 20-06 Build a Model
As part of its overall plant modernization and cost reduction program, Western Fabrics' management has
decided to install a new automated weaving loom. In the capital budgeting analysis of this equipment, the IRR of the project
was found to be 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 the end of
each year. In the event that the loom is purchased, the manufacturer will contract to maintain and service it for a fee of
$20,000 per year paid at the end of each year. The loom falls in the MACRS 5-year class, and Western's marginal
federal-plus-state tax rate is 40%.
Gardial Automation Inc., maker of the loom, has offered to lease the loom to Westen for $70,000 upon delivery and
installation (at t=0) plus 4 additional annual lease payments of $70,000 to be made at the ends 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 eight 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 and entirely new plant in 4 years, so
it has no interest in either leasing or owning the proposed loom for more than that period.
a. Should the loom be leased or purchased?
First, we want to lay out all of the input data in the problem.
INPUT DATA
Invoice Price		$250,000
Length of loan		4
Loan Interest rate		10%
Maintenance fee		$20,000
Tax Rate		40%
Lease fee		$70,000
Equipment expected life		8
Expected salvage value		$0
Market value after 4 years		$42,500
Book value after 4 years		$42,500
First, we can determine the annual loan payment that must be made on the new equipment. We will do so using the
function wizard for PMT.
Annual loan payment =		You can use Excel's PMT function $78,868
Year		1	2	3	4
Beginning loan balance		$250,000	$196,132	$136,878	$71,698
Interest payment		$25,000	$19,613	$13,688	$7,170
Principal payment		$53,868	$59,254	$65,180	$71,698
Ending loan balance		$196,132	$136,878	$71,698	$0
Now, we see that the decision being made is whether to purchase the equipment at a net cost of $250,000 (with annual
payments of $78,868) or lease the equipment and make annual payments of $70,000. To make this decision, we must
analyze the incremental cash flows.
Before proceeding with our NPV analysis we must determine the schedule of depreciation charges for this new
equipment.
MACRS 5-year Depreciation Schedule
Year	1	2	3	4	5	6
Depr. Rate	20%	32%	19%	12%	11%	6%
Depr. Exp.	$50,000	$80,000	$47,500	$30,000	$27,500	$15,000
We can now construct our table of incremental cash flows from these two alternatives. Remember, that the appropriate
discount rate in this scenario is the after tax cost of borrowing, or: 10%*(1-40%) = 6%.
NPV LEASE ANALYSIS OF INCREMENTAL CASH FLOWS
	Year =		0	1	2	3	4
Cost of ownership
Purchase cost			($250,000)
Loan proceeds			$250,000
After-tax interest payment				($15,000)	($11,768)	($8,213)	($4,302)
Principal payment				($53,868)	($59,254)	($65,180)	($71,698)
Maintenance cost				($20,000)	($20,000)	($20,000)	($20,000)
Tax savings from maintenance cost				$8,000	$8,000	$8,000	$8,000
Tax savings from depreciation				$20,000	$32,000	$19,000	$12,000
Salvage value							$42,500
Net cash flow from ownership			$0	($60,868)	($51,022)	($66,393)	($33,500)
PV cost of ownership			($185,112)
Cost of leasing
Lease payment			($70,000)	($70,000)	($70,000)	($70,000)	($70,000)
Tax savings from lease payment			$28,000	$28,000	$28,000	$28,000	$28,000
Net cash flow from leasing			($42,000)	($42,000)	($42,000)	($42,000)	($42,000)
PV cost of leasing			($187,534)
Cost Comparison
PV ownership cost @ 6%		($185,112)
PV of leasing @ 6%		($187,534)
Net Advantage to Leasing		($2,423)
Our NPV Analysis has told us that there is a negative advantage to leasing. We interpret that as an indication that the
firm should forego the opportunity to lease and buy the new equipment.
b. The salvage value is clearly the most uncertain cash flow in the analysis. Assume that the appropriate salvage value
pre-tax discount rate is 15 percent. What would be the effect of a salvage value risk adjustment on the decision?
All cash flows would remain unchanged except that of the salvage value. Our new array of cash flows would resemble the
following:
Standard discount rate		10%
Salvage value rate		15%
Year =		0	1	2	3	Operating cash flows for t=4. 4	Salvage value cash flow in t=4. 4
Net cash flow		$0	($60,868)	($51,022)	($66,393)	($76,000)	$42,500
PV of net cash flows		$0	($57,422)	($45,410)	($55,744)	($60,199)	$30,108
NPV of ownership		($188,667)
New Cost Comparison
PV ownership cost @ 6%		($188,667)
PV of leasing @ 6%		($187,534)
Net Advantage to Leasing		$1,133
Under this new assumption of using a greater discount factor for the salvage value, we find that the firm should lease, and
not buy, the equipment.
c. Assuming that the after-tax cost of debt should be used to discount all anticipated cash flows, at what lease payment
would the firm be indifferent to either leasing or buying?
We will use the Goal Seek function to determine the lease payment that makes the Net Advantage to Leasing zero.
Crossover =	Insert Goal Seek function here. 69,096