Start with the partial model in the file Ch18 P06 Build a Model.xls on the textbook’s
Web site. As part of its overall plant modernization and cost reduction program,
Western Fabrics’s management has decided to install a new automated weaving
loom. In the capital budgeting analysis of this equipment, the IRR of the project
was found to be 20% versus the project’s required return of 12%.
The loom has an invoice price of $250,000, including delivery and installation
charges. The funds needed could be borrowed from the bank through a 4-year amortized
loan at a 10% interest rate, with payments to be made at the end of each year. In
the event the loom is purchased, the manufacturer will contract to maintain and service
it for a fee of $20,000 per year paid at the end of each year. The loom falls in the
MACRS 5-year class, and Western’s marginal federal-plus-state tax rate is 40%.
Aubey Automation Inc., maker of the loom, has offered to lease the loom to
Western for $70,000 upon delivery and installation (at t = 0) plus four additional annual
lease payments of $70,000 to be made at the end of Years 1 to 4. (Note that
there are five lease payments in total.) The lease agreement includes maintenance
and servicing. Actually, the loom has an expected life of 8 years, at which time its
expected salvage value is zero; however, after 4 years its market value is expected to
equal its book value of $42,500. Western plans to build an entirely new plant in 4
years, so it has no interest in either leasing or owning the proposed loom for more
than that period.
a. Should the loom be leased or purchased?
b. The salvage value is clearly the most uncertain cash flow in the analysis. What
effect would a salvage value risk adjustment have on the analysis? (Assume that
the appropriate salvage value pre-tax discount rate is 15%.)
c. Assuming that the after-tax cost of debt should be used to discount all anticipated cash
flows, at what lease payment would the firm be indifferent to either leasing or buying

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