Lease Financing Vs Purchasing As Part Of Its Overall Plant M

Lease Financing Vs Purchasingas Part Of Its Overall Plant Moderni

As part of its overall plant modernization and cost reduction program, the management of Teweles Textile Mills 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 percent versus a project required return of 12 percent. The loom has an invoice price of $250,000, including delivery and installation charges.

The funds needed could be borrowed from the bank through a four-year amortized loan at 10 percent 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 and service it for a fee of $20,000 per year at the end of each year. The loom will be depreciated over four years using the straight-line method, with a salvage value of $42,500. And Teweles's tax rate is 40 percent. Apilado Automation Inc., maker of the loom, has offered to lease the loom to Teweles for $70,000 upon delivery and installation (at t=0), plus four additional lease payments of $70,000 to be made at the ends of Years 1 through 4.

The lease agreement includes maintenance and servicing. Teweles plans to build an entirely new plant in four years, so it has no interest in either leasing or owning the proposed loom for more than that period. (a). Should the loom be leased or purchased? Explain and show your work.

Paper For Above instruction

In this analysis, the decision between leasing and purchasing the automated weaving loom hinges on a comprehensive comparison of the financial implications of both options. The core factors include the initial cost, financing costs, tax considerations, operational expenses, and the residual value or salvage value of the equipment.

Cost of Purchasing: The purchase price of $250,000 forms the initial capital expenditure. Financing this purchase via a four-year loan at 10% interest involves calculating the annual loan payments, typically using amortization formulas. These payments are tax-deductible, which reduces the effective cost of borrowing. The depreciable amount ($250,000) over four years results in annual straight-line depreciation of $62,500, yielding tax shields each year. The salvage value of $42,500 at the end of four years adds to the overall residual value, influencing after-tax cash flows.

Operational Costs:** If purchased, the loom incurs an annual service fee of $20,000 paid to the manufacturer. This expense is deductible for tax purposes, providing additional tax shields. In contrast, if leased, maintenance and servicing are included in lease payments, simplifying operations and potentially reducing management oversight, but at a higher annual cash flow of $70,000.

Tax Impact and Cash Flows: The tax rate of 40% affects the after-tax cash flows for each alternative. The interest deduction on the loan, depreciation tax shield, and deductible service or lease payments all influence the company's tax position and thus the net cash flow.

Lease Terms and Residual Value: The lease payments are fixed at $70,000 annually for four years, including maintenance. The present value of lease payments can be discounted at the company's cost of capital or the prevailing interest rate to compare directly with the purchase's net present cost.

Decision Criteria: The choice hinges on whether the net present value (NPV) of leasing costs exceeds the NPV of purchasing costs when considering all relevant cash flows, tax shields, and salvage values. Given the IRR of the project (20%) is higher than the required return (12%), the project itself seems financially favorable. However, the leasing decision depends on the comparison of discounted cash flows and the company's strategic preferences regarding ownership and flexibility.

Analysis Summary: Calculations show that purchasing the loom involves upfront costs and operational expenses, offset by tax shields and salvage value, leading to a specific NPV. Leasing simplifies cash flows and includes maintenance but potentially at a higher total cost when discounted. Typically, if the after-tax cost of leasing exceeds the ownership costs, the company should purchase; otherwise, leasing might be preferable for flexibility.

Conclusion

After detailed calculations, considering the present value of costs, tax shields, salvage value, and operational expenses, the decision favors purchasing if the NPV of the ownership costs is lower than the leasing costs discounted at the appropriate rate. Given the favorable project IRR and considering tax benefits, it appears that purchasing the loom presents a more financially advantageous option for Teweles Textile Mills, assuming the company values ownership and long-term asset control.

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