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 25% versus a project required return of 11%.
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 12% 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 $18,000 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 19%, 31%, 18%, 14%, 10%, and 5%.
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 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 $43,500. 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. Round your answers to the nearest dollar.
A. Should the loom be leased or purchased?
PV cost of owning at 7.2% is $----- .
PV cost of leasing at 7.2% is $ ----.
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? Round your answer to the nearest dollar.
NPV is $--------