Ms. Matthews is currently weighing her options for new refrigeration equipment she is
considering for her expansion of frozen yogurt offerings. This equipment would be important for distribution and storage facilities to store yogurt before delivery to retail operations. She is currently working out a deal with Blizzard Inc.; a US ice cream manufacturer that is offering to lease brand new equipment it has acquired to ACH. Ms. Matthews is also considering just purchasing the equipment up front from the original equipment manufacturer. She is trying to understand why Blizzard Inc. would lease equipment to ACH, and what the benefits and drawbacks of leasing would potentially have for ACH. She also wants to know what type of lease is being considered, and what the effects would be on ACH's statement of financial position. She wants you to include this information in your report.
ACH is considering investing in new manufacturing equipment that would cost $10M if purchased today from the original manufacturer. The CCA rate applicable to this asset is 35%. Alternatively, ACH could lease the equipment for $2.15M annually over a six year term, with payments at the beginning of each year. The salvage value is expected to be $1,500,000 at the end of six years, according to ACH's CFO Justine Brown, and the disposal of the assets will not trigger any tax effects. The applicable tax rate is 25%. At the end of the lease, ACH has the option to purchase the equipment at a bargain price.
Ms. Matthews wants your advice on whether or not ACH should purchase or lease the asset. She wants you to determine the effect of having payments at the end of the year, rather than at the beginning of the year. She also believes that the salvage value estimation by Justine Brown is incorrect, and that the salvage value could be as high as $2.7M after six years. She wants to know how a salvage value of $2.7M will impact the purchase or leasing decision, when payments are either at the beginning or end of a period. Blizzard Inc. has also offered to have lease payments at the end of each period, as long as ACH puts up a $800K security deposit. Ms. Matthews wants you to evaluate the impact of the security deposit option.
Finally, Ms. Matthews wants to know what lease payment would effectively lead to indifference between leasing and purchasing, under the original offer (i.e., six payments at the beginning of the year and a $1.5M salvage value).
After taking these scenarios into account, Ms. Matthews would like you to recommend what ACH should ultimately do.
Weighted Average Cost of Capital (WACC)
Ms. Matthews wants you to use the weighted average cost of capital (WACC) as the required return. ACH currently has 10 million common shares that are trading at $30 per share. The dividend is expected to increase to $3.00 per share in the next period. ACH also has 1 million preferred shares that get $1M in dividends and are currently trading at $20 per share. Ms. Matthews wants you to determine the cost of preferred equity and common equity, using dividends and share prices. The anticipated constant growth rate for common dividends is 2%.
The total market value of debt ACH expects to have going into this investment is $120M. The before-tax cost of debt is approximately 8%, excluding the impact of re-financing at a lower rate of 6% for $50M. Ms. Matthews wants you to use the 8% interest rate as the proxy for the cost of debt, but needs you to determine the after-tax cost of debt to be used in the WACC. A tax rate of 25% has been suggested for use in the analysis.
Please help Ms Mathews.