You are considering the purchase of a new zippy fabricating machine for your firm, Cherry Enterprises, Inc. CEI makes novelty items for wholesale to retail outlets located in tourist traps. The purchase of the zippy will allow CEI to market a new product, a walking stick with built-in bear repellant. In order to analyze the decisions to manufacture and sell the walking sticks and to lease the zippy, you have collected the following data, some of which may be relevant (all dollars in 2016 prices):
Cost of zippy = $8,000,000
Useful (and depreciable) life of zippy = 10 years
Salvage value (market and depreciation) of zippy = $0
Expected walking stick sales volume (in lots of 1000) = 2500/year
Wholesale price per 1000 lot of walking sticks = $999
Annual zippy maintenance contract costs = $110,000 (the only fixed cash cost)
Average variable cost per lot of walking sticks = $525
Additional working capital (supplies inventory) required at beginning of year 1 = $200,000
Current equity = $50,000,000
Current debt = $50,000,000
Marginal tax rate for CEI = 30%
Inflation rate = .03
Zippy can be financed in several ways. The following data pertain to financing options:
Required return on equity (real) = .05
Bank loan interest rate available, given current capital structure = .055
Lease contract with payments made in 10 equal annual installments, beginning at start of
lease period. Lease contract includes maintenance costs. Payment = $1,100,000
Evaluate the zippy as a business opportunity for CEI. Evaluate the lease financing option for the zippy as well. Use the “easy way” to value a financial lease which is to discount the lease cash flows at the after-tax interest rate that the firm would pay on an equivalent loan. Although CEI is a tax-paying entity and could benefit from the use of MACRS depreciation, for simplicity here use straight-line depreciation expense recognition.