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Big Sky Mining Company must install $1.5 million of new machinery in its Nevada mine. It can...

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Finance

Big Sky Mining Company must install $1.5 million of newmachinery in its Nevada
mine. It can obtain a bank loan for 100% of the purchase price, orit 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 forinsurance, property
taxes, and maintenance.
(3) The firm’s tax rate is 25%.
(4) The loan would have an interest rate of 15%. It would benonamortizing, with only
interest paid at the end of each year for four years and theprincipal repaid at Year 4.
(5) The lease terms call for $400,000 payments at the end of eachof the next 4 years.
(6) Big Sky Mining has no use for the machine beyond the expirationof the lease, and
the machine has an estimated residual value of $250,000 at the endof the 4th year.
a. What is the cost of owning?
b. What is the cost of leasing?
c. What is the NAL of the lease?

Answer & Explanation Solved by verified expert
4.4 Ratings (700 Votes)

Discount rate = After tax cost of debt = 15%*(1-25%) = 11.25%
a] 0 1 2 3 4
Interest on loan at 15% $        2,25,000 $    2,25,000 $     2,25,000 $         2,25,000
Repayment of loan $                     -   $                 -   $                  -   $      15,00,000
MACRS depreciation $        4,99,950 $    6,66,750 $     2,22,150 $         1,11,150
Cash flows of owning:
After tax interest = Interest expense*(1-25%) $      -1,35,000 $   -1,35,000 $   -1,35,000 $       -1,35,000
Repayment of principal [Installment-Interest] $     -15,00,000
Tax shield on depreciation = Depreciation*25% = $        1,24,988 $    1,66,688 $        55,538 $            27,788
After tax residual value = 250000*(1-25%) = $                     -   $                 -   $                  -   $         1,87,500
Cash flows of owning $          -10,013 $        31,688 $       -79,463 $     -14,19,713
PVIF at 11.25% 1 0.89888 0.80798 0.72627 0.65283
PV at 11.25% $            -9,000 $        25,603 $       -57,711 $       -9,26,831
NPV of owning $       -9,67,939
b] PV cost of leasing = -400000*(1-25%)*(1.1125^4-1)/(0.1125*1.1125^4) = $       -9,25,787
c] NAL of leasing = -925787-(-967969) = $ 42,152
As the NAL of leasing is positive, the truck should be leased.
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