Sadik Industries must install $1 million of new machinery in its Texas plant. It can obtain a 6-year bank loan for 100% of the cost at a 14% interest rate with equal payments at the end of each year. Sadik's tax rate is 34%. The equipment falls in the MACRS 3-year class. Alternatively, a Texas investment banking firm that represents a group of investors can arrange a guideline lease calling for payments of $320,000 at the end of each year for 3 years. Under the proposed lease terms, the Sadik must pay for insurance, property taxes, and maintenance. 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 Year 3. The best estimate of this market value is $200,000, but it could be much higher or lower under certain circum- stances. If purchased at Year 3, the used equipment would fall into the MACRS 3-year class. Sadik would actually be able to make the purchase on the last day of the year (i.e., slightly before Year 3), so Sadik would get to take the first depreciation expense at Year 3 (the remaining depreciation expenses would be from Year 4 through Year 6). On the time line, Sadik would show the cost of purchasing the used equipment at Year 3 and its depreciation expenses starting at Year 3. To assist management in making the proper lease-versus-buy decision, you are asked to answer the following questions: a. What is the net advantage of leasing? Should Sadik take the lease? b. Consider the $200,000 estimated residual value. How high could the residual value get before the net advantage of leasing falls to zero?
Sadik Industries must install $1 million of new machinery in its Texas plant. It can obtain a 6-year bank loan for 100% of the cost at a 14% interest rate with equal payments at the end of each year. Sadik's tax rate is 34%. The equipment falls in the MACRS 3-year class. Alternatively, a Texas investment banking firm that represents a group of investors can arrange a guideline lease calling for payments of $320,000 at the end of each year for 3 years. Under the proposed lease terms, the Sadik must pay for insurance, property taxes, and maintenance. 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 Year 3. The best estimate of this market value is $200,000, but it could be much higher or lower under certain circum- stances. If purchased at Year 3, the used equipment would fall into the MACRS 3-year class. Sadik would actually be able to make the purchase on the last day of the year (i.e., slightly before Year 3), so Sadik would get to take the first depreciation expense at Year 3 (the remaining depreciation expenses would be from Year 4 through Year 6). On the time line, Sadik would show the cost of purchasing the used equipment at Year 3 and its depreciation expenses starting at Year 3. To assist management in making the proper lease-versus-buy decision, you are asked to answer the following questions: a. What is the net advantage of leasing? Should Sadik take the lease? b. Consider the $200,000 estimated residual value. How high could the residual value get before the net advantage of leasing falls to zero?
Financial Management: Theory & Practice
16th Edition
ISBN:9781337909730
Author:Brigham
Publisher:Brigham
Chapter19: Lease Financing
Section: Chapter Questions
Problem 7P
Related questions
Question
Transcribed Image Text:Sadik Industries must install $1 million of new machinery in its Texas plant. It can obtain
a 6-year bank loan for 100% of the cost at a 14% interest rate with equal payments at the
end of each year. Sadik's tax rate is 34%. The equipment falls in the MACRS 3-year class.
Alternatively, a Texas investment banking firm that represents a group of investors
can arrange a guideline lease calling for payments of $320,000 at the end of each year for
3 years. Under the proposed lease terms, the Sadik must pay for insurance, property taxes,
and maintenance.
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 Year 3. The best estimate of this
market value is $200,000, but it could be much higher or lower under certain circum-
stances. If purchased at Year 3, the used equipment would fall into the MACRS 3-year
class. Sadik would actually be able to make the purchase on the last day of the year (i.e.,
slightly before Year 3), so Sadik would get to take the first depreciation expense at Year 3
(the remaining depreciation expenses would be from Year 4 through Year 6). On the time
line, Sadik would show the cost of purchasing the used equipment at Year 3 and its
depreciation expenses starting at Year 3.
To assist management in making the proper lease-versus-buy decision, you are asked
to answer the following questions:
a. What is the net advantage of leasing? Should Sadik take the lease?
b. Consider the $200,000 estimated residual value. How high could the residual value
get before the net advantage of leasing falls to zero?
Expert Solution
This question has been solved!
Explore an expertly crafted, step-by-step solution for a thorough understanding of key concepts.
This is a popular solution!
Trending now
This is a popular solution!
Step by step
Solved in 3 steps
Recommended textbooks for you
EBK CONTEMPORARY FINANCIAL MANAGEMENT
Finance
ISBN:
9781337514835
Author:
MOYER
Publisher:
CENGAGE LEARNING - CONSIGNMENT
EBK CONTEMPORARY FINANCIAL MANAGEMENT
Finance
ISBN:
9781337514835
Author:
MOYER
Publisher:
CENGAGE LEARNING - CONSIGNMENT