Response to the following problem:
Sadik Industries must install $1 million of new machinery in its Texas plant. It can obtain a bank loan for 100 percent of the required amount. Alternatively, a Texas investment banking firm that represents a group of investors believes that it can arrange for a lease financing plan.
Assume that these facts apply:
(1) The equipment falls in the MACRS 3-year class.
(2) Estimated maintenance expenses are $50,000 per year.
(3) The firm's tax rate is 34 percent.
(4) If the money is borrowed, the bank loan will be at a rate of 14 percent, amortized in 3 equal installments at the end of each year .
(5) The tentative lease terms call for payments of $320,000 at the end of each year for 3 years. The lease is a guideline lease.
(6) Under the proposed lease terms, the lessee must pay for insurance, property taxes, and maintenance.
(7) Sadik must use the equipment if it is to continue in business, so it will almost certainly want to acquire the property at the end of the lease. If it does, then under the lease terms it can purchase the machinery at its fair market value at Year 3. The best estimate of this market value is $200,000, but it could be much higher or lower under certain circumstances.
If purchased at Year 3, the used equipment would fall into the MACRS 3-year class. Sadik would actually be able to make the purchase on the last day of the year (i.e., slightly before Year 3), so Sadik would get to take the first depreciation expense at Year 3 (the remaining depreciation expenses would be at Year 4 through Year 6). On the time line, Sadik would show the cost of the used equipment at Year 3 and its depreciation expenses starting at Year 3.
To assist management in making the proper lease-versus-buy decision, you are asked to answer the following.
a. What is the net advantage of leasing? Should Sadik take the lease?
b. Consider the $200,000 estimated residual value. How high could the residual value get before the net advantage of leasing falls to zero?
c. The decision almost can be considered a bet on the future residual value. Do you think the residual cash flows are equal in risk to the other cash flows? If not, how might you address this issue?
( Hint: if you discount a negative cash flow at a higher rate, you get a better NPV, the NPV of a negative cash flow stream is less negative at high discount rates.)