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5 Apr 2018

Bandbox is considering a lease vs. buy decision on a large piece of equipment. The equipment will be obsolete after 3-years (no value at end of life). The company can borrow the funds needed to purchase this equipment at a rate of 10%. The company has a tax rate of 40%. If the company buys the equipment, it will be able to reduce its taxes by $640 million due to depreciation tax savings (interest deductions and a reduction in income due to maintenance also providing tax savings). All together, owning the equipment results in a positive contribution(due to all tax savings) of $208 per year in the first two years. In the third year, cash flow would be negative due to the repayment of the loan. As such, ownership cash flows are estimated to be as follows:

Year1: +208

Year2: +208

Year3: -4,592

Leasing provides fewer tax shields, but no debt. As such, it's cash flows should be the same every year and negative. The cash flows expected if Bandbox leases this equipment would be:

Year1: -1260

Year2: -1260

Year3: -1260

What is the after-tax cost of debt for Bandbox?

What is the NPV of the cash flows from ownership(Use after-tax cost of debt as interest rate)

What is the NPV of the cash flows from leasing?(use after-tax cost of debt as interest rate)

Based upon your answers in the prior 3 problems, should Bandbox buy or lease this equipment?

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Sixta Kovacek
Sixta KovacekLv2
8 Apr 2018

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Replacement Decision, Computing After-Tax Cash Flows, Basic NPV Analysis

Okmulgee Hospital (a large metropolitan for-profit hospital) is considering replacing its MRI equipment with a new model manufactured by a different company. The old MRI equipment was acquired three years ago, has a remaining life of five years, and will have a salvage value of $100,000. The book value is $2,000,000. Straight-line depreciation with a half-year convention is being used for tax purposes. The cash operating costs of the existing MRI equipment total $1,000,000 per year.

The new MRI equipment has an initial cost of $5,000,000 and will have cash operating costs of $500,000 per year. The new MRI will have a life of five years and a salvage value of $1,000,000 at the end of the fifth year. MACRS depreciation will be used for tax purposes. If the new MRI equipment is purchased, the old one will be sold for $500,000. The company needs to decide whether to keep the old MRI equipment or buy the new one. The cost of capital is 12 percent. The combined federal and state tax rate is 40 percent.

You must use the Exhibit 19B.1 and Exhibit 19B.2 present value tables and Exhibit 19.5 to solve the following problem.

Required:

Compute the NPV of each alternative. When required, round your computations and final answers to the nearest dollar. If the NPV is negative, enter your answer as a negative value.

Old MRI equipment $
New MRI equipment $

Use the information here for the following 7 questions (7-13).

Warf Computers needs specialized equipment for production.

The company can buy the equipment from Clapton Acoustical Equipment for $5 million.


The equipment falls in the three-year MACRS depreciation class.
MACRS Depreciation Allowances
Property Class
Year 3-year 5-year 7-year
1 33.33% 20.00% 14.29%
2 44.44% 32.00% 24.49%
3 14.82% 19.20% 17.49%
4 7.41% 11.52% 12.49%
5 11.52% 8.93%
6 5.76% 8.93%
7 8.93%
8 4.45%
At the end of four years, market value of the equipment is expected to be $600,000.

Alternatively, the company can lease from Hendrix Leasing. Lease contract calls for four annual payments of $1.3 million due at the beginning of the year.

Security deposit of $300,000 will be returned when the lease expires.
Warf Computers can issue bonds with a yield of 11 percent and the company has a marginal tax rate of 35%.

If Warf leases, what is the after-tax lease payment in year 3?

If Warf leases, what is the lost after-tax salvage value in year 4?

If Warf leases, what is the lost depreciation tax shield in year 2?

If Warf leases, what is the incremental cash flow in year 0?

If the lease contract includes an option for Warf to purchase the equipment at its fair market value upon the lease’s expiration, how will the option influence the value of the lease?

If the lease contract includes a cancellation option that allows Warf to cancel the lease with 30 days’ notice, how will the option influence the value of the lease?

If the lease contract includes an option for Warf to purchase the equipment at $250,000 upon the lease’s expiration, how will the option influence the value of the lease?

FINANCIAL MANAGEMENT

Lewis Securities Inc. has decided to acquire a new market data and quotation system for its Richmond home office. The system receives current market prices and other information from several online data services and then either displays the information on a screen or stores it for later retrieval by the firm’s brokers. The system also permits customers to call up current quotes on terminals in the lobby.

The equipment costs $1,000,000 and, if it were purchased, Lewis could obtain a term loan for the full purchase price at a 10% interest rate. Although the equipment has a 6-year useful life, it is classified as a special-purpose computer and therefore falls into the MACRS 3-year class. If the system were purchased, a 4-year maintenance contract could be obtained at a cost of $20,000 per year, payable at the beginning of each year. The equipment would be sold after 4 years, and the best estimate of its residual value is $200,000. However, because real-time display system technology is changing rapidly, the actual residual value is uncertain.

As an alternative to the borrow-and-buy plan, the equipment manufacturer informed Lewis that Consolidated Leasing would be willing to write a 4-year guideline lease on the equipment, including maintenance, for payments of $260,000 at the beginning of each year. Lewis’s marginal federal-plus-state tax rate is 40%. You have been asked to analyze the lease-versus-purchase decision and, in the process, to answer the following questions.

a. (1) Who are the two parties to a lease transaction?

(2) What are the five primary types of leases, and what are their characteristics?

(3) How are leases classified for tax purposes?

(4) What effect does leasing have on a firm’s balance sheet?

(5) What effect does leasing have on a firm’s capital structure?

b. (1) What is the present value cost of owning the equipment? (Hint: Set up a time line that shows the net cash flows over the period t = 0 to t = 4, and then find the PV of these net cash flows, or the PV cost of owning.)

(2) Explain the rationale for the discount rate you used to find the PV.

What is Lewis’s present value cost of leasing the equipment? (Hint: Again, construct a time line.)

What is the net advantage to leasing (NAL)? Does your analysis indicate that Lewis should buy or lease the equipment? Explain.

e. Now assume that the equipment’s residual value could be as low as $0 or as high as $400,000, but $200,000 is the expected value. Because the residual value is riskier than the other relevant cash flows, this differential risk should be incorporated into the analysis. Describe how this could be accomplished. (No calculations are necessary, but explain how you would modify the analysis if calculations were required.) What effect would the residual value’s increased uncertainty have on Lewis’s lease-versus-purchase decision?

The lessee compares the cost of owning the equipment with the cost of leasing it. Now put yourself in the lessor’s shoes. In a few sentences, how should you analyze the decision to write or not to write the lease?

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