SolutionsMidterm2

SolutionsMidterm2 - Economics 181: Corporate Finance...

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Unformatted text preview: Economics 181: Corporate Finance Solutions: Midterm #2 Wadia Haddaji April 2, 2008 (1)(20 points) Seniveht, Inc., is considering whether it should lease or buy a machine. The machine costs $120 , 000. The machine will be depreciated straight-line to zero in years 1, 2 and 3. The machine will then be sold for $10 , 000 in year 3. The economic marginal tax rate for your company is 30%. The purchase can be financed with debt at an interest rate of 10%. Alter- natively, the firm can lease the machine for the three years, and pay $50 , 000 every year (i.e., at the end of years 1, 2 and 3). (a) (10 points) Analyze whether Seniveht should buy the machine or lease it . solutions: The yearly depreciation tax shield lost by Seniveht is 120 , 000 3 30% = 12 , 000. Its after- tax lease payment is 50 , 000(1- . 30) = 35 , 000. Also, by leasing, Seniveht forgoes the after-tax cash flow of 10 , 000(1- . 30) = 7 , 000 resulting from the sale of the machine at the end of the third year. The lease vs. buy cash flows are therefore as follows for Seniveht. 1 1 2 3 Purchase savings 120,000 Depr. tax shield lost-12,000-12,000-12,000 A-T lease payment-35,000-35,000-35,000 Machine resale-7,000 Net cash flows 120,000-47,000-47,000-54,000 The net present value of leasing as opposed to buying is then given by (we discount at the after-tax rate of 10%(1- . 30) = 7%) NPV = 120 , 000- 47 , 000 1 . 07- 47 , 000 (1 . 07) 2- 54 , 000 (1 . 07) 3 =- 9 , 057. Thus the company should buy the machine. (b) (5 points) Suppose that the lessor will bear the maintenance costs in case that Seniveht leases the machine. If Seniveht buys the machine, it will have to spend $7 , 000 every year on maintenance (i.e., at the end of years 1, 2 and 3). Should Seniveht buy the machine given the new terms of the leasing contract? (For simplicity, use the same discount rate that you used in part (a) to calculate the present value of the mainte- nance costs.) solutions: Now, there is additional value for the company when it leases the machine. This additional value is a result of saving maintenance costs. The present value of these (after-tax) costs is PV (maintenance costs) = 7 , 000(1- . 30) a 3 , 7% = 4 , 900(2 . 6243) = 12 , 859. 2 Thus, the total net present value of leasing vs. buying is now equal to 12,859-9,057 = 3,802. The company should therefore lease the machine. (c) (5 points) Suppose that, due to economies of scale, the maintenance cost is lower for the lessor than it is for Seniveht. What is the highest maintenance cost, for which the lessor will benefit from the leasing contract? (Assume that the economic marginal tax rate and the interest rate for the lessor are the same as those for Seniveht.) solutions: Let C denote the annual maintenance cost for the lessor. The net present value from the point of view of the lessor is NPV =- 120 , 000 + 47 , 000 1 . 07 + 47 , 000 (1 . 07) 2 + 54 , 000 (1 . 07) 3- . 7 C * a 3 , 7% = 9 , 057- . 7...
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SolutionsMidterm2 - Economics 181: Corporate Finance...

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