A B C D E F G H

1 Copyright © 2023 Cengage Learning Canada, Inc.

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3 Build-A-Model Solution
4 to accompany
5 Spreadsheet Problem 15-8
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7 As part of its overall plant modernization and cost reduction program, Western Fabrics' management has decided to install a new auto
8 weaving loom. In the capital budgeting analysis of this equipment, the IRR of the project was found to be 20% versus the project's req
9 return of 12%.
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12 The loom has an invoice price of $250,000, including delivery and installation charges. The funds needed could be borrowed from the
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
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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 loo
14 in the CCA rate of 35%, and Western's marginal tax rate is 40%.
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18 Aubey Automation Inc., maker of the loom, has offered to lease the loom to Westen for $70,000 upon delivery and installation (at t=0) p
19 additional annual lease payments of $70,000 to be made at the ends of Years 1 through 4. (Note that there are 5 lease payments in tota
lease agreement includes maintenance and servicing. Actually, the loom has an expected life of eight years, at which time its expected s
20 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
21 plant in 4 years, so it has no interest in either leasing or owning the proposed loom for more than that period.
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24 a. Should the loom be leased or purchased?
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26 First, we want to lay out all of the input data in the problem.
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28 INPUT DATA
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30 Invoice Price $250,000
31 Length of loan 4
32 Loan Interest rate 10%
Book value is a term
33 Maintenance fee $20,000 referring to the difference
34 Tax Rate 40% between acquisition cost
35 Lease fee $70,000 and accumulated
36 Equipment expected life 8 depreciation. So, book
37 Expected salvage value $0 value may deviate from
the ending UCC.
38 Market value after 4 years $42,500
39 Book value after 4 years $42,500
40 CCA Rate 35%
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42 First, we can determine the annual loan payment that must be made on the new equipment. We will do so using the
43 function wizard for PMT. You can use Excel's PMT
44 function
45 Annual loan payment = $78,868
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47 Year 1 2 3 4
48 Beginning loan balance $250,000 $196,132 $136,878 $71,698
 A B C D E F G H
49 Interest payment $25,000 $19,613 $13,688 $7,170
50 Principal payment $53,868 $59,254 $65,180 $71,698
51 Ending loan balance $196,132 $136,878 $71,698 $0
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55 Now, we see that the decision being made is whether to purchase the equipment at a net cost of $250,000 (with annual
56 payments of $78,868) or lease the equipment and make annual payments of $70,000. To make this decision, we must analyze
57 the incremental cash flows.
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 A B C D E F G H
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Before proceeding with our NPV analysis we must determine the schedule of depreciation charges for this new equipment.
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62 CCA Depreciation Schedule
63 Year Beg. UCC CCA End UCC
64 1 $250,000 $43,750 $206,250
65 2 $206,250 $72,188 $134,063
66 3 $134,063 $46,922 $87,141
67 4 $87,141 $30,499 $56,641
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69 We can now construct our table of incremental cash flows from these two alternatives. Remember, that the appropriate
70 discount rate in this scenario is the after tax cost of borrowing, or: 10%*(1-40%) = 6%.
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72 NPV LEASE ANALYSIS OF INCREMENTAL CASH FLOWS
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74 Year = 0 1 2 3 4
75 Cost of ownership
76 Purchase cost ($250,000)
77 Loan proceeds $250,000
78 After-tax interest payment ($15,000) ($11,768) ($8,213) ($4,302)
79 Principal payment ($53,868) ($59,254) ($65,180) ($71,698)
80 Maintenance cost ($20,000) ($20,000) ($20,000) ($20,000)
81 Tax savings from maintenance cost $8,000 $8,000 $8,000 $8,000
82 Tax savings from depreciation $17,500 $28,875 $18,769 $12,200
83 Tax saving from terminal loss $5,657
84 Salvage value $42,500
85 Net cash flow from ownership $0 ($63,368) ($54,147) ($66,624) ($27,644)
86 PV cost of ownership ($185,807)
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88 Note: You may use the formula for PV of CCA tax shield to calculate the PV cost of ownership which equals to $186,462, cash
89 outlay.
90 Cost of leasing
91 Lease payment ($70,000) ($70,000) ($70,000) ($70,000) ($70,000)
92 Tax savings from lease payment $28,000 $28,000 $28,000 $28,000 $28,000
93 Net cash flow from leasing ($42,000) ($42,000) ($42,000) ($42,000) ($42,000)
94 PV cost of leasing ($187,534)
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96 Cost Comparison
97 PV ownership cost @ 6% ($185,807)
98 PV of leasing @ 6% ($187,534)
99 Net Advantage to Leasing ($1,728)
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101 Our NPV Analysis has told us that there is a negative advantage to leasing. We interpret that as an indication that the firm
102 should forego the opportunity to lease and buy the new equipment.
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 A B C D E F G H
104 b. The salvage value is clearly the most uncertain cash flow in the analysis. What effect would a salvage value risk
105 adjustmnet have on the analysis? (Assume that the appropriate salvage value pre-tax discount rate is 15 percent.)
Op
106 plu
107 All cash flows would remain unchanged except that of the salvage value. Our new array of cash flows would resemble the ter
108 following: sal
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110 Standard discount rate 10% sal
111 Salvage value rate 15%
112 Sal
113 Year = 0 1 2 3 4 4 disc
114 Net cash flow $0 ($63,368) ($54,147) ($66,624) ($70,144) $42,500 tax
115 PV of net cash flows $0 ($59,781) ($48,191) ($55,939) ($55,560) $30,108 disc
cell
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117 NPV of ownership ($189,363)
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119 New Cost Comparison
120 PV ownership cost @ 6% ($189,363)
121 PV of leasing @ 6% ($187,534)
122 Net Advantage to Leasing $1,828
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124 Under this new assumption of using a greater discount factor for the salvage value, we find that the firm should lease, and not
125 buy, the equipment.
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127 c. Assuming that the after-tax cost of debt should be used to discount all anticipated cash flows, at what lease payment
128 would the firm be indifferent to either leasing or buying?
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130 We will use the Goal Seek function to determine the lease payment that makes the Net Advantage to Leasing zero.
131 Insert Goal Seek
132 Crossover = 69,355 function here.
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134 Click Data, What-if Analysis, Goal Seek, and then set c98 to zero by changing c34
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136 Note: You may use formula approach to calculate the PV of CCA tax shield. However, the formula approach is based on the
137 assumption that the asset pool is open forever. When the ending UCC and the market value of an asset at the end of its useful life do
138 not deviate much, then using spreadsheet as shown above leads to similar conclusion as does the formula approach. See the
accompanying spreadsheet "Build a Model Formula Approach."
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ment has decided to install a new automated
und to be 20% 8 versus the project's required
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s needed could
12 be borrowed from the bank
ach year. In the event that the loom is
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paid at the end of each year. The loom falls
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pon delivery18and installation (at t=0) plus 4
hat there are
195 lease payments in total.) The
ght years, at which time its expected salvage
00. Western20 plans to build an entirely new
that period.21
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42 the
will do so using
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250,000 (with55annual
is decision, 56
we must analyze
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s for this new equipment.
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er, that the appropriate
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hich equals88 to $186,462, cash
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101that the firm
an indication
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104risk
salvage value
ate is 15 percent.)
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Operating cash flow
106 plus tax saving from
flows would107resemble the terminal loss excluding
108 salvage value.
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110 salvage value
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112 Salvage value is
113 discounted using after
114 tax salvage value
115 discount rate shown in
cell c110
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124 lease, and not
he firm should
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127payment
at what lease
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e to Leasing130
zero.
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roach is based
136on the
at the end of137
its useful life do
la approach.138
See the
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Copyright © 2023 Cengage Learning Canada, Inc.

Build-A-Model Alternate Solution (Formula Approach)

to accompany
Spreadsheet Problem 15-8

This worksheet contains an alternative solution to the Build a Model problem by using formula approach to calculate CCA. Hen
weaving loom is kept open even if the lease contract is over.

A. Should the loom be leased or purchased?

Input Data

New Equipment cost $250,000 KEY OUTPUT

Project life 4
Equip. Salvage Value at end of the project $42,500 buy
Annual Maintenance $20,000 because of the net advantage of leasing is
Tax Rate 40%
Loan interest rate 10%
Annual rental charge $70,000
CCA rate 35%
After-tax cost of debt 6.0%

Western Fabrics
Year = 0 1 2
I. Cost of Owning
1. Equipment $250,000
II. Leasing cash flows
2.lease payment ($70,000) ($70,000) ($70,000)
3. Tax savings from lease payment $28,000 $28,000 $28,000
4. Maintenance Cost $20,000 $20,000
5. Tax savings from maintenance ($8,000) ($8,000)
6. Residual value
7. Net cash flow ($42,000) ($30,000) ($30,000)
8. PV net cash flow at 6.0% ($179,617.1)
III. CCA tax ownership benefit
9 PV of forgone CCA tax shiedl ($71,455)
10. PV cost of leasing ($251,072)
IV. Net advantage to leasing (NAL)
11. Net advantage of leasing = Cost of equipment - |PV cost of leasing|
= $250,000 - $251,072
= ($1,072.0)

b. The Salvage value is clearly the most uncertain cash flow in the analysis. What effect would a salvage risk adjustment have
(Assume that the appropriate salvage value pre-tax discount rate is 15%)

After tax discount rate = 9%

PV net cash flow = ($176,061.24)
PV cost of leasing = ($247,516.06)
NAL = Cost of equipment - |PV cost of leasing|
 = $250,000 - $247,516.06
= $2,483.94

When the salvage value pre-tax discount rate is 15%, the net advantage to lease is at $2,484. So it's preferrable for Western
Fabrics' to lease.

C. Assuming that the after-tax cost of debt should be used to discount all anticipated cash flows, at what lease payment would
firm be indifferent to either leasing or buying?

We will use the Goal Seek function to determine the lease payment that makes the Net Advantage to Leasing zero.

Crossover = $69,599.87

Click Data, What-if Analysis, Goal Seek, and then set c38 to zero by changing c15
a Approach)

a approach to calculate CCA. Hence it assumes that the asset pool for the

he net advantage of leasing is ($1,071.97)

3 4

($70,000) ($70,000)
$28,000 $28,000
$20,000 $20,000
($8,000) ($8,000)
($42,500)
($30,000) ($72,500)

ld a salvage risk adjustment have on the analysis?

4. So it's preferrable for Western

ows, at what lease payment would be

e to Leasing zero.