Rock Creek offers a truly unique golfing venue in the southern region of Alabama...

 

A case analysis by Lanot, Maceres, Martin & Pedrena

COMPANY BACKGROUND

- Public Golf Course owned by a private corporation- Lee Jeffries is the Club Manager.- The club has been using 40 battery-powered carts for five years.

The carts they owned were old and: - Fully-depreciated - Being bought at $200 cash for each.

Two salespersons offered Jeffries 40 new gasoline-powered carts.

CASE BACKGROUND

Salesman A Proposal:- Sell carts at $2,240 each and - Expected Salvage Value = $240 each after 5 years.

Salesman B Proposal:

- Lease the golf carts for $500per cart per year.

- Payable at the end of the year for five years.

- Contract could be cancelled at any time with 90 days notice.

Either case:- Out-of-pocket operating cost is $420 per cart per year.- Annual revenue from renting the carts is $84,000 for the fleet.

JEFFRIES’ ANALYSIS:Go for purchasing the carts outright because…

- If purchased outright: - Carts will “pay for themselves” in less than 2 years,

even ignoring salvage value.- If leased:

- Carts will cost $2500 each (which is higher than $2240)- RCGC will not get salvage proceeds.

DIRECTOR’S REACTIONNot clear which is the better alternative

“even ignoring inflation, spending $2240 now may not be better than spending $500 over the next five years”

- If purchased outright: - Company will have to borrow funds at 8% interest cost.- Effective interest cost is actually lower due to 34 cents saving on

taxes for every dollar of interest expense.- Lease payments are also tax deductable.

Assume that in order to purchase the carts, RCGC would have to borrow $89600 at 8% interest for 5 years, repayable in 5 equal year end installments.

Prepare an amortization schedule for this loan, showing how much of each year's payment is for interest and how much is applied to pay principal.

QUESTION # 1

YearBal. of Equal Interest Reduction Ending

Principal Annual Portion of of Balance of@beg. of yr. Payment Payment Principal Principal

0 $ 89,600

1 $ 89,600 $ 22,440 $ 7,168 $ 15,272 $ 74,328

2 $ 74,328 $ 22,440 $ 5,946 $ 16,494 $ 57,834

3 $ 57,834 $ 22,440 $ 4,626 $ 17,814 $ 40,020

4 $ 40,020 $ 22,440 $ 3,201 $ 19,239 $ 20,781

5 $ 20,781 $ 22,440 $ 1,662 $ 20,778 $ 3

ANSWER TO Q # 1

Amortization Schedule for the loan

Amount $ 89,600.00 PV factor (5yrs, 8%) = 3.993Rate 8% Annual Installment = $ 22,439.27 Term 5 yrs

Assume salesperson B's company also would be willing to sell the carts outright at $2,240 per cart.

Given the proposed lease terms, and assuming the lease is outstanding for 5 years, what interest rate is implicit in the lease? (Ignore tax impacts to the leasing company when calculating this implicit rate.)

Why is this implicit rate different from the 8% that RCGC may have to pay to borrow the funds needed to purchase the carts.

QUESTION # 2

ANSWER TO Q # 2

PV = PMT * [ PV factor for n = 5 years; i = ?? per year ]

$2,240 = $500 * [ PVOA factor for n = 5 years; i = ?? per year ]

$2,240 / $500 = [ PVOA factor for n = 5 years; i = ?? per year ]

4.48 = [ PVOA factor for n = 5 years; i = ?? per year ]

http://www.accountingcoach.com/online-accounting-course/81Xpg07.html

ANSWER TO Q # 2

PV = PMT * [ PV factor for n = 5 years; i = ?? per year ]

$2,240 = $500 * [ PVOA factor for n = 5 years; i = ?? per year ]

$2,240 / $500 = [ PVOA factor for n = 5 years; i = ?? per year ]

4.48 = [ PVOA factor for n = 5 years; i = ?? per year ]

4.48 = PVOA factor for n = 5 years; i = 4% per year

http://www.accountingcoach.com/online-accounting-course/81Xpg07.html

ANSWER TO Q # 2

PV = PMT * [ PV factor for n = 5 years; i = ?? per year ]

$2,240 = $500 * [ PVOA factor for n = 5 years; i = ?? per year ]

$2,240 / $500 = [ PVOA factor for n = 5 years; i = ?? per year ]

4.48 = [ PVOA factor for n = 5 years; i = ?? per year ]

4.48 = PVOA factor for n = 5 years; i = 4% per year

http://www.accountingcoach.com/online-accounting-course/81Xpg07.html

Should RCGC buy the carts from A, or lease them from B?

(Assume that if the carts are purchased, RCGC will use accelerated depreciation for income tax purposes, based on an estimated life of 5 years and an estimated residual value of $240 per cart. The accelerated depreciation percentages for years 1-5, respectively are 35%, 26%, 15.6%, 11.7%, and 11.7%)

QUESTION # 3

Capital Budgeting DecisionProposal A: Buy the carts at $2,240 each

Investment $ 89,600.00 Scrap Value $ 9,600.00

ANSWER TO Q # 3

Year Inflowout-of-pocket EBITDA Interest Depreciation EBT Tax

After-tax inflow

Discount NPV

a b c = a - b d e f = c - (d + e) g = f * 34% h = c - g Factor

0 81,600.00 $ (81,600.00)

1 84,000.00 16,800.00

67,200.00 7,168.00 28,000.00 32,032.00 10,890.88

56,309.12 0.926 $ 52,142.25

2 84,000.00 16,800.00

67,200.00 5,946.00 20,800.00 40,454.00 13,754.36

53,445.64 0.857 $ 45,802.91

3 84,000.00 16,800.00 67,200.00 4,626.00 12,480.00 50,094.00 17,031.96

50,168.04 0.794 $ 39,833.42

4 84,000.00 16,800.00

67,200.00 3,201.00 9,360.00 54,639.00 8,577.26

48,622.74 0.735 $ 35,737.71

5 93,600.00 16,800.00

76,800.00 1,662.00 9,360.00 65,778.00 22,364.52

54,435.48 0.681 $ 37,070.56

$ 128,986.86

Proposal B: Lease the carts @ $500 per cart per year

Expected Annual Revenue $ 84,000.00

Annual Out-of-pocket Oper. Exp. $ 16,800.00

Annual Lease Payments $ 20,000.00 $ 36,800.00 Annual Pre-tax nte inflow $ 47,200.00 Tax (34% * $47,200) $ 16,048.00 Annual After Tax inflow $ 31,152.00 Discount Factor for 8%, 5yrs (Table A) 3.993

Net present value (NPV) $ 124,389.94

Proposal A $ 128,986.86 Proposal B $ 124,389.94

Answer: Buy the carts from A

Assume arbitrarily that purchasing the carts has an NPV that is $4000 higher than the NPV of leasing them.

How much would B have to reduce the proposed annual lease payment to make leasing as attractive as purchasing the cart?

QUESTION # 4

Solution:

Differential NPV $ 4,000.00 Discount Factor for 8%,

5yrs (Table A) 3.993Differential Annual After Inflow $ 1,001.75 Tax rate 34%Differential Annual Pre-tax Inflow $ 1,517.81 Divide by No. of carts 40Incremental decrease in lease payts $ 37.95

Checking:Proposal:

Expected Annual Revenue 84,000.00

Annual Out-of-pocket Oper. Exp. 16,800.00 Annual Lease Payments 20,000.00 36,800.00 Annual Pre-tax nte inflow 47,200.00 Tax (34% * $47,200) 16,048.00 Annual After Tax inflow 31,152.00 Discount Factor for 8%, 5yrs (Table A) 3.993

Net present value (NPV) 124,389.94

Expected Annual Revenue 84,000.00

Annual Out-of-pocket Oper. Exp. 16,800.00 Annual Lease Payments 18,482.00 35,282.00 Annual Pre-tax nte inflow 48,718.00 Tax (34% * $47,200) 16,564.12 Annual After Tax inflow 32,153.88 Discount Factor for 8%, 5yrs (Table A) 3.993

Net present value (NPV) 128,390.44

4,000.51

ANSWER TO Q # 4

Put text here...

TO BUY OR TO LEASE?(nonmonetary considerations)

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kim

nadia

Salamat Po.