For Case III Below Is The Right Answer Please Revise Our Ans

For Case Iii Below Is the Right Answer Please Revise Ours Accordingly

For Case III, below is the right answer, please revise ours accordingly. 1. It appears the decision to acquire the equipment and perform the image upgrade has already been made. As such, we can assume that we simply need to provide the best solution based on the total cost and/or annual cost of financing. Since the case occurs in current time and the CarMax beta is actual, we can assume today’s market conditions (i.e., last year’s return on the market was an outlier as is this year's; therefore, we would like to use a market return of 7% to find the risk premium). The DCF approach and the CAPM approach provide different costs of equity. SML derived returns need not be same as implied discount rates even when CAPM is applicable and markets are efficient. This is because the stock returns and discount rates will be same mathematically only when the discount rates are expected to remain constant over the forecast period. The single period return of CAPM changes every year as the market changes with economic conditions, implying that the market discount rates are changing. When the implied discount rates are varying, the ex-ante returns will have no resemblance to the implied discount rate for the year in consideration. Additionally, the stock from this company is private and thus should be adjusted higher as investors would require a higher liquidity premium since the stock is not publicly traded. The method you submitted (averaging the DCF and the CAPM) is a reasonable method of determining the cost of equity. The assumptions I should make on leasing the equipment. First, the company has good credit (they will receive a favorable rate of 10%). The tax rate is given in the problem. Estimated maintenance expenses are $50,000 per year. Though they can finance for a longer period, they can lease for only 3 years. The tentative lease terms call for payments of $260,000 at the end of each year for 3 years. The lease is a guideline lease. The equipment falls into a MACRS 3-year class. Thompkins will want to buy the equipment at the end of the lease. It can purchase at fair market value. The best estimate of the market value is $200,000. Essentially, Section 179 of the IRS tax code allows businesses to deduct the full purchase price of qualifying equipment and/or software purchased or financed during the tax year. That means that if you buy (or lease) a piece of qualifying equipment, you can deduct the full purchase price from your gross income. It’s an incentive created by the U.S. government to encourage businesses to buy equipment and invest in themselves.

Paper For Above instruction

In capital budgeting and investment analysis, selecting the optimal financing option involves a comprehensive understanding of various financial metrics and statutory incentives, particularly when acquiring equipment such as those involved in imaging upgrades. The decision in Case III, which is already set to acquire equipment, requires evaluating the total cost of ownership and financing options to ascertain the most advantageous financial strategy. This analysis applies to both the initial acquisition costs and subsequent operational expenses, including lease payments, maintenance, and tax considerations.

Given the current market conditions, it is appropriate to assume a market return of approximately 7%, which acts as the baseline for calculating the risk premium for this case, considering fluctuations in annual returns and market efficiency. Importantly, while Discounted Cash Flow (DCF) and the Capital Asset Pricing Model (CAPM) are vital tools for estimating the cost of equity, they often yield differing results due to their underlying assumptions. DCF relies on projected cash flows discounted at an appropriate rate, whereas CAPM incorporates market risk premiums and beta coefficients to derive the expected return. Since markets are dynamic and market risk premiums change annually, the calculable discount rate should reflect these variations, especially for private companies where additional risk premiums, such as liquidity premiums, are justified.

In this regard, the cost of equity is adjusted upward to account for illiquidity, recognizing that private company stocks necessitate higher premiums. Averaging the results from DCF and CAPM can provide a balanced estimate of the required return on equity, accommodating uncertainties inherent in market fluctuations. Based on the company's creditworthiness, a favorable borrowing rate of approximately 10% is estimable, reflecting its credit profile and prevailing interest rates.

The lease arrangement is analyzed to understand its implications for cash flow and tax savings. The lease is structured for a three-year term with annual payments of $260,000, which aligns with the equipment's classification within the Modified Accelerated Cost Recovery System (MACRS) 3-year category. Under this system, depreciation deductions accelerate tax savings during the early years of ownership, effectively improving cash flow.

Furthermore, estimated annual maintenance expenses of $50,000 are crucial for operating cost analysis, as they impact overall profitability and cash expenditure. Although the equipment can be financed over an extended period if necessary, the current lease terms are limited to three years, with the intent to purchase at the end of the lease at an estimated fair market value of $200,000. This estimated residual value, coupled with Section 179 of the IRS tax code, enables substantial tax deductions. Section 179 permits qualifying businesses to deduct the full purchase price of capital expenditures in the year of purchase—encouraging investment in equipment by allowing immediate tax relief.

Thus, when evaluating the investment, one must consider the tax advantages conferred by Section 179, the depreciation benefits under MACRS, and the overall cost of leasing versus buying. The decision hinges on the comparative analysis of discounted cash flows, tax savings, and residual value, all integrated into a comprehensive financial model to guide the optimal acquisition strategy.

References

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• Internal Revenue Service (IRS). Section 179 Deduction. Retrieved from https://www.irs.gov/publications/p946
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