start with the partial model in the file ch18 p06 build a model xls on the textbook 530055 | Homework Solutions

Start with the partial model in the file Ch18 P06 Build a Model.xls on the textbook”s Web site. As part of its overall plant modernization and cost reduction program, Western Fabrics”s management has decided to install a new automated weaving loom. In the capital budgeting analysis of this equipment, the IRR of the project was found to be 20% versus the project”s required return of 12%. 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 10% interest rate, with payments to be made at the end of each year. In the event the loom is purchased, the manufacturer will contract to maintain and service it for a fee of $20,000 per year paid at the end of each year. The loom falls in the MACRS 5-year class, and Western”s marginal federal-plus-state tax rate is 40%. Aubey Automation Inc., maker of the loom, has offered to lease the loom to Western for $70,000 upon delivery and installation (at t = 0) plus four additional annual lease payments of $70,000 to be made at the end of Years 1 to 4. (Note that there are five lease payments in total.) The lease agreement includes maintenance and servicing. Actually, the loom has an expected life of 8 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 $42,500. Western plans to build an entirely new plant in 4 years, so it has no interest in either leasing or owning the proposed loom for more than that period.

a. Should the loom be leased or purchased?

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b. The salvage value is clearly the most uncertain cash flow in the analysis. What effect would a salvage value risk adjustment have on the analysis? (Assume that the appropriate salvage value pre-tax discount rate is 15%.)

c. Assuming that the after-tax cost of debt should be used to discount all anticipated cash flows, at what lease payment would the firm be indifferent to either leasing or buying?

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