91Ó°ÊÓ

As part of its overall plant modernization and cost reduction program, the management of tanner-Woods Textile Mills 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 percent versus a project required return of 12 percent. 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 percent interest rate, with payments to be made at the end of each year. In the event that 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 Tanner-Woods's marginal federal-plus-state tax rate is 40 percent. The applicable MACRS rates are \(20,32,19,12,11,\) and 6 percent. United Automation Inc., maker of the loom, has offered to lease the loom to tannerWoods for \(\$ 70,000\) upon delivery and installation (at \(t=0\) ) plus 4 additional annual lease payments of \(\$ 70,000\) to be made at the end of Years 1 through 4 . (Note that there are 5 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 \(\$ 42,500 .\) Tanner-Woods 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? b. The salvage value is clearly the most uncertain cash flow in the analysis. Assume that the appropriate salvage value pre-tax discount rate is 15 percent. What would be the effect of a salvage value risk adjustment on the decision? c. The original analysis assumed that Tanner-Woods would not need the loom after 4 years. Now assume that the firm will continue to use it after the lease expires. Thus, if it leased, Tanner-Woods would have to buy the asset after 4 years at the then existing market value, which is assumed to equal the book value. What effect would this requirement have on the basic analysis? (No numerical analysis is required; just verbalize.

Step by step solution

01

Understand the Purchase Decision

For purchasing, calculate the Net Present Value (NPV) of all cash flows, considering the initial cost, loan repayments, maintenance costs, tax benefits from depreciation, and the salvage value. The initial cost is $250,000. Calculate annual loan payments using the 4-year 10% amortized loan formula, considering tax, which results in after-tax payments.

02

Determine Depreciation Tax Benefits

Use the MACRS rates to find annual depreciation values and associated tax shields, considering the company's 40% tax rate. Calculate the tax shield by multiplying the depreciation by the tax rate for each year.

03

Calculate Salvage Value

The salvage value after 4 years is expected to be $42,500. Discount this amount to its present value using a 12% discount rate (project required return), as it's a part of cash inflows when considering owning versus leasing.

04

Evaluate Lease Decision

In a lease scenario, the company will make 5 lease payments of $70,000 ($70,000 at t=0 and $70,000 at the end of each year from Year 1 to Year 4), which includes maintenance. Compare the present value of these 5 payments discounted at the project's required return rate of 12% against the costs of purchasing.

05

Analyze Risk of Salvage Value

Consider the effect of a salvage value risk adjustment. Use a pre-tax discount rate of 15% for salvage value, to account for increased risk. Compare how the present value of this adjusted salvage value alters the purchase NPV.

06

Evaluate Extended Usage Scenario

Consider the scenario where the firm needs the loom beyond 4 years. If transitioning from lease to own would require buying the loom at book value at Year 4, analyze qualitatively how this additional purchase affects total cost over an extended period, mainly influencing decisions under unchanged lease conditions.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Depreciation Tax Benefits

When businesses purchase equipment, they can recover some of the costs over time through depreciation. This is a method that allows companies to allocate the cost of the equipment over its useful life. In capital budgeting, depreciation can be quite beneficial because it reduces taxable income, resulting in tax savings for the company. This is often called a depreciation tax shield.

For example, let’s consider the loom that Tanner-Woods Textile Mills wants to purchase, which falls under the Modified Accelerated Cost Recovery System (MACRS) 5-year class. The MACRS rates given are: 20%, 32%, 19%, 12%, 11%, and 6%.

To calculate the tax benefit from depreciation:

• Multiply the loom’s cost by each MACRS rate to find the annual depreciation.
• Then, multiply each annual depreciation by the company’s tax rate (40%) to find the yearly tax shield.

By reducing the taxable income, these tax benefits improve the net cash flows of the project, making an important difference to the bottom line.

Lease Versus Purchase

Deciding between leasing and buying equipment like the loom involves comparing costs and benefits of each option. Here’s a simplified breakdown of what needs to be considered:

With purchasing, Tanner-Woods would pay $250,000 upfront and also incur yearly costs like maintenance and loan repayments. At the end of 4 years, they will have a salvage value of $42,500 which needs to be considered too.

Leasing, on the other hand, involves fewer upfront costs. United Automation Inc. offers the loom for lease at $70,000 upon delivery plus 4 additional annual payments of $70,000, with maintenance included.

To make an informed decision, the company should:

• Calculate the Net Present Value of purchasing the loom which involves up-front payment, running cost and the salvage value.
• Calculate the present value of the lease payments.

This helps in understanding the total cost over the 4-year period and determines which option is financially better.

Net Present Value

Net Present Value (NPV) is a crucial concept in capital budgeting. It helps determine the profitability of an investment by comparing the present value of cash inflows to the present value of cash outflows. In simple terms, it reflects the difference between how much money you can make from the investment and how much you spend on it initially.

To calculate the NPV for purchasing the loom, Tanner-Woods would:

• Consider all cash flows: initial cost, loan repayments (adjusted for tax), the savings from depreciation tax benefits, and the salvage value at the end of the usage period.
• Discount these future cash flows back to their present value using a discount rate, often the required rate of return, which in this case is 12%.

Having a positive NPV indicates that the investment is generating value over its cost, while a negative NPV suggests a potential loss.

Internal Rate of Return

Internal Rate of Return (IRR) is the rate at which the NPV of all cash flows from an investment equals zero. It effectively represents the return on investment expected from the project.

In the case of Tanner-Woods, the IRR of purchasing the loom is 20%, compared to a required return of 12%. This indicates that the project is expected to generate a return above the company’s threshold for acceptable investments.

• Testing IRR against the company’s required rate of return helps decide if a project should be undertaken.
• An IRR exceeding the required rate suggests profitability, whereas an IRR below indicates a more questionable investment.

In capital budgeting, the IRR is instrumental in ranking and selecting projects based on their potential to add value to the firm.