Carmichael Cleaners needs a new steam finishing machine that costs $100,000. The
ID: 2715184 • Letter: C
Question
Carmichael Cleaners needs a new steam finishing machine that costs $100,000. The company is evaluating whether it should lease or purchase the machine. The equipment falls into the MACRS 3-year class, and it would be used for 3 years and then sold, because the firm plans to move to a new facility at that time. The estimated value of the equipment after 3 years is $30,000. A maintenance contract on the equipment would cost $3,000 per year, payable at the beginning of each year. Alternatively, the firm could lease the equipment for 3 years for a lease payment of $29,000 per year, payable at the beginning of each year. The lease would include maintenance. The firm is in the 20% tax bracket, and it could obtain a 3-year simple interest loan, interest payable at the end of the year, to purchase the equipment at a before-tax cost of 10%.
(Note: MACRS rates for Years 1 to 4 are 0.3333, 0.4445, 0.1481, and 0.0741.)
Question: What is the principal repayment in Year 2?
$33,233
$0
$6,979
$10,000
Question: What is the after-tax interest payment in Year 3?
$8,000
$2,924
$3,656
$6,000
Question: How much is the after-tax salvage value at the end of Year 3 if Carmichael Cleaners buys the machine?
$20,964
$24,000
$30,000
$25,482
Question: Should Carmichael Cleaners buy or lease the machine?
Buy, the net advantage to leasing is $5,734
Lease, the net advantage to leasing is $5,734
Buy, the net advantage to leasing is $4,822
Lease, the net advantage to leasing is $4,822
a.$33,233
b.$0
c.$6,979
d.$10,000
Explanation / Answer
Answer (A)
b. Principal repayment in year 2 = $ 0
The Loan is taken for 3 years at a simple pre-tax interest rate of 10%. The life of the project is 3 years. As no further information is provided we can assume that the loan will be repaid at the end of the 3 year period only.
Therefore annual instalment = 0
Answer (B)
Total Loan Amount = $ 100,000
Pre-tax Interest on $ 100,000 at 10% = $ 10,000
After tax interest on loan = $ 10,000 * (1-0.20) = $ 10,000 * 0.8 = $ 8,000
Answer (C)
c.After tax salvage value = $ 25,482
Salvage Value = $ 30,000
Depreciated value of the machine after three years = $ 100000 – ($100000*(0.3333+0.4445+0.1481)
= $ 100,000 - $ 100000 * 0.9259
= $ 100,000 - $ 92,590 = $ 7,410
Net capital gain = $ 30,000 - $ 7,410 = $ 22,590
Tax on capital gains = $ 22,590 * 20% = $ 4,518 (since no separate rate for capital gains is given it is assumed at the same rate as income tax rate)
After-tax Salvage Value = $ 30,000 - $ 4,518 = $ 25,482
Answer (d)
The decision is to lease as net present value of the purchase decision is negative and the Net Advantage to Leasing is positive. However as the discount rate is not provided the calculation was done at 10% as IRR of purchase cash flows is -74% and IRR of advantage is coming to -83%
Calculation is shown below
Calculation of income flows 0 1 2 3 Investment -100000 maintenance -3000 -3000 -3000 Depreciation -33330 -44450 -14810 At MACRS rate Tax Shield on Depreciation 6666 8890 2962 Depreciation * tax rate salvage value 30000 Tax on salvage value -4518 Total Cash Flows -103000 -29664 -38560 13634 irr -74% Net Present Value at 10% -151591.62 Leas payments 29000 29000 29000 Present Value of Lease at 10% 79330.58 Net Advantage to Leasing = Present Value of Lease - Present value of purcahse 230922.19 Advantage 132000.00 58664.00 67560.00 -13634.00 IRR -83%