Reference no: EM132484793

The Randolph Teweles Company (RTC) has decided to acquire a new truck. One alternative is to lease the truck on a 4-year guideline contract for a lease payment of $10,000 per year, with payments to be made at the beginning of each year. The lease would include maintenance. Alternatively, RTC could purchase the truck outright for $40,000, financing the purchase by a bank loan for the net purchase price and amortizing the loan over a 4-year period at an interest rate of 10% per year. Under the borrow-to-purchase arrangement, RTC would have to maintain the truck at a cost of $1,000 per year, payable at year end. The truck falls into the MACRS 3-year class. It has a residual value of $10,000, which is the expected market value after 4 years, when RTC plans to replace the truck irrespective of whether it leases or buys. RTC has a marginal federal-plus-state tax rate of 40%.

Question a. What is RTC's PV cost of leasing?

Question b. What is RTC's PV cost of owning? Should the truck be leased or purchased?

Question c. The appropriate discount rate for use in the analysis is the firm's after-tax cost of debt. Why?

Problems

1) Two companies, Energen and Hastings Corporation, began operations with identical balance sheets. A year later, both required additional fixed assets at a cost of $50,000. Energen obtained a 5-year, $50,000 loan at an 8% interest rate from its bank. Hastings, on the other hand, decided to lease the required $50,000 capacity for 5 years, and an 8% return was built into the lease. The balance sheet for each company, before the asset increases, follows:

Current assets: $25,000 Debt: $50,000

Fixed assets: $125,000 Equity: $100,000

Total assets $150,000 Total claims: $150,000

Question a. Show the balance sheets for both firms after the asset increases, and calculate each firm's new debt ratio. (Assume that the lease is not capitalized.)

Question b. Show how Hastings's balance sheet would look immediately after the financing if it capitalized the lease.

2) Big Sky Mining Company must install $1.5 million of new machinery in its Nevada mine. It can obtain a bank loan for 100% of the purchase price, or it can lease the machinery. Assume that the following facts apply.

(1) The machinery falls into the MACRS 3-year class.

(2) Under either the lease or the purchase, Big Sky must pay for insurance, property taxes, and maintenance.

(3) The firm's tax rate is 40%.

(4) The loan would have an interest rate of 15%.

(5) The lease terms call for $400,000 payments at the end of each of the next 4 years.

(6) Big Sky Mining has no use for the machine beyond the expiration of the lease, and the machine has an estimated residual value of $250,000 at the end of the 4th year. What is the NAL of the lease?