As part of its overall plant modernization and cost reduction program, Western Fabrics' 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 $260,000, 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 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 Western's marginal federal-plus-state tax rate is 40%.
Gardial Automation Inc., the maker of the loom, has offered to lease the loom to Westen 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. 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.
Required:
(a) Should the loom be leased or purchased?
(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?