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Borrow and Buy Decision

Loan Amount
Repayment
Interest rate
Cost of Capital
Loan Instalment
Tax rate
Depreciation Schedule
Year 1
Year 2
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.




To assist management in making the proper lease-versus-buy decision, you are asked to answer
the following questions:

a. Assuming that the lease can be arranged, should the firm lease or borrow and buy the
equipment? (Hint: In this situation, the firm plans to use the asset beyond the term of the lease.
Thus, the residual value becomes a cost to leasing in Year 3. Also, there is no Year 3 residual
value tax consequence, as the firm cannot immediately deduct the Tear 3 purchase price from
taxable income).

b. Consider the $200,000 estimated residual value. Is it appropriate to discount it at the same rate
as the other cash flows? What about the other cash flows are they all equally risky? (Hint:
Riskier cash flows are normally discounted at higher rates, but when the cash flows are costs
rather than inflows, the normal procedure must be reversed).
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 irrelevant for
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 but risky future
cash inflows at a lower discount rate. The residual value is the value which company will have to pay to buy the equipment for future use
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 outflow so we would prefer
using a lower rate as using a higher rate would make the lease look more attractive. Hence use of lower rate is justified.
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
Note: as maintainenace and other expenses are paid under purchase as well as lease options, these costs are irrelevant for
For a risk averase decision maker it makes sense to discount more risky cash flows inflows at a higher discount rate but risky future
cash inflows at a lower discount rate. The residual value is the value which company will have to pay to buy the equipment for future use
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 outflow so we would prefer
using a lower rate as using a higher rate would make the lease look more attractive. Hence use of lower rate is justified.