GR Industries needs to expand its milling capacity, and has selected a model that fits its needs. The first cost is $80,000, and the model is estimated to have a 12-year economic service life. The estimated salvage value after 12 years if $5,000. GR management believes that the machine will increase its net before-tax cash flow by about $18,000 per year. This will give the company a before-tax rate of return of about 20%. The company’s after-tax minimum acceptable rate of return is 12%, and its tax rate is 40%. Unfortunately, RG Industries does not have enough capital to buy the machine for cash, but it can borrow $60,000 from the bank. The loan would have to be repaid in eight end-of-year payments of involving $7,500 in principal per year, plus interest of 12% on the unpaid debt at the beginning of each year. If the machine is purchased, assume that it can be depreciated using straight-line depreciation over 10 years, and that any gain when it is sold will be taxed as ordinary income.
The manufacturer of the new machine also offers a leasing program. The contract for the lease requires a refundable deposit of $8,000, which will be returned at the end of the 12 years. The annual rental payments are $12,000 a year for 12 years, payable at the beginning of each year.
(a) If GR Industries had $80,000 to invest in the milling machine, would it be a good investment? Why or why not?
(b) Prepare a table showing after-tax cash flow for debt financing, and one for leasing. What is the after-tax cost of the money “borrowed” by leasing (i.e., the difference between the $8,000 deposit for leasing, and the $20,000 down payment for debt financing)? What would you recommend to GR management? Explain.
(c) Is the increase in revenue from buying the machine big enough to cover the required cash flows for your recommended decision?
(d) What other factors should GR Industries consider in determining whether this machine meets its needs, and comparing it with off-the-shelf solutions available from other vendors?