4 (20-5) A.

Sadik Industries must install $1 million of new machinery in its

Texas
plant. It can obtain a bank loan for 100% of the required amount. Alternately,
a Texas investment banking firm which 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 firms tax rate is 34%.

4) If the money is borrowed, the bank loan will be at a rate of 14%, 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 that time. The best estimate of this market value is $200,000,
but it could be much higher or lower under certain circumstances.
Borrow and Buy Decision
Loan Amount
Repayment
Interest rate
Cost of Capital
Loan Instalment
Tax rate
Depreciation Schedule
Year 1
 Year 2
Year 3

Loan Amortization Schedule

year Beginning Amount Instalment
1 $ 1,000,000 $ 430,731
2 $ 709,269 $ 430,731
3 $ 377,835 $ 430,731

Cost of Borrowing and owning

Year 0
Loan Payment
Interest
tax savings on Interest

Depreciation
tax savings on depreciation

Net cash Flow

PV Cost of Owning $730,991.68

Cost of Leasing
Year 0
Lease payment
Tax savings on lease payment
market Value of Machine
Net cash flow
PV Cost of leasing $685,752.02

Since PV cost of leasing is lower, lease the machine.

Note: as maintainenace and other expenses are paid under purchase as well as lease options, these costs are irrelevan
decision making.

Part b.
For a risk averase decision maker it makes sense to discount more risky cash flows inflows at a higher discount rate
cash inflows at a lower discount rate. The residual value is the value which company will have to pay to buy the equi
at the end of lease term. The risk associated with this is much higher. But as this is not a cash inflow but a cash outflo
using a lower rate as using a higher rate would make the lease look more attractive. Hence use of lower rate is justifi
 1,000,000
3 years
14%
9.24%
($430,731.48)
34%

33.33%
 44.45%
14.81%

Interest Principle repayment Ending Loan

$ 140,000 $ 290,731 $ 709,269
$ 99,298 $ 331,434 $ 377,835
$ 52,897 $ 377,835 $ -

1 2 3
$430,731.48 $430,731.48 $430,731.48
$ 140,000 $ 99,298 $ 52,897
$ 47,600.00 $ 33,761.18 $ 17,984.93

333300 444500 148100

113322 151130 50354

$ 269,809.48 $ 245,840.30 $ 362,392.55

1 2 3
320,000 320,000 320,000
108800 108800 108800
200,000
211,200 211,200 411,200

options, these costs are irrelevant for

nflows at a higher discount rate but risky future

will have to pay to buy the equipment for future use
ot a cash inflow but a cash outflow so we would prefer
Hence use of lower rate is justified.