Your Company is evaluating the acquisition of a new piece of equipment that has an installed cost of $ 10,000,000. The equipment will add $2,000,000 to earnings before interest and taxes each year for the next 12 years. Depreciation for tax purposes will be on a straight line basis for 7 years. The Company has a desired rate of return of 12%. The Company’s marginal tax rate is 30%. The company is evaluating the following options regarding acquisition of the equipment.
Purchase for cash up front.
Put $3,000,000 down and get a bank loan for the remaining $ 7,000,000. The bank loan with carry interest at 5% per year and payments of interest and $1,000,000 of principal will be due at the end of each of the next 7 years.
Pay $10,000,000 cash but obtain the funds by issuing bonds. The Bonds will be due and payable at the end of 10 years and will carry 6% interest. Interest will be payable semi-annually (3% each six month). The Company will have to pay floatation costs of $ 2,000,000 up front.
Lease the equipment through a leasing company. Title to the equipment will transfer, to the Company, at the end of the lease. The lease will be for 10 years and will carry an imputed interest rate of 4%. The lease will require quarterly (every three months) payments of $ 304,555.98.
Depreciation expense and interest expense are both tax deductible.
Requirements:
Calculate the payback period for the investment under each option.
Calculate the net present value under each option.
Decide on the best financing option for the Company and defend your decision.
Decide which financing option would be the best for cash planning for the Company and defend why that would be the best option.
You must turn in all calculations (spreadsheets).
Be sure to take all tax considerations into account in all calculations.