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Chapter 5: Q1P-g (page 542)

Howell Auto Parts is considering whether to borrow funds and purchase an asset or to lease the asset under an operating lease arrangement. If the company purchases the asset, the cost will be \(10,000. It can borrow funds for four years at 12 percent interest. The firm will use the three-year MACRS depreciation category (with the associated four-year write-off). Assume a tax rate of 35 percent.

The other alternative is to sign two operating leases, one with payments of \)2,600 for the first two years, and the other with payments of $4,600 for the last two years. In your analysis, round all values to the nearest dollar.

g. Which alternative should be selected, based on minimizing the present value of after-tax costs?

Short Answer

Expert verified

The borrow-purchase alternative should be selected as it has a lower cost than the leasing option.

Step by step solution

01

Information available

The present value of the after-tax cost of leasing = $7,585

The present value of the after-tax cost of borrow-purchase= $6,937

02

Decision regarding the selection of the alternative

The present value of the after-tax cost of the borrow-purchase option is less than the present value of the after-tax cost of the leasing alternative, so the organisation should select the borrow-purchase decision.

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Most popular questions from this chapter

Question: The management of Mitchell Labs decided to go private in 2002 by buying in all 2.80 million of its outstanding shares at \(24.80 per share. By 2006, management had restructured the company by selling off the petroleum research division for \)10.75 million, the fiber technology division for \(8.45 million, and the synthetic products division for \)20 million. Because these divisions had been only marginally profitable, Mitchell Labs is a stronger company after the restructuring. Mitchell is now able to concentrate exclusively on contract research and will generate earnings per share of $1.10 this year. Investment bankers have contacted the firm and indicated that if it reentered the public market, the 2.80 million shares it purchased to go private could now be reissued to the public at a P/E ratio of 15 times earnings per share.

b. What is the total value to the company from (1) the proceeds of the divisions that were sold, as well as (2) the current value of the 2.80 million shares (based on current earnings and an anticipated P/E of 15)?

Question: The management of Mitchell Labs decided to go private in 2002 by buying in all 2.80 million of its outstanding shares at \(24.80 per share. By 2006, management had restructured the company by selling off the petroleum research division for \)10.75 million, the fiber technology division for \(8.45 million, and the synthetic products division for \)20 million. Because these divisions had been only marginally profitable, Mitchell Labs is a stronger company after the restructuring. Mitchell is now able to concentrate exclusively on contract research and will generate earnings per share of $1.10 this year. Investment bankers have contacted the firm and indicated that if it re-entered the public market, the 2.80 million shares it purchased to go private could now be reissued to the public at a P/E ratio of 15 times earnings per share.

c. What is the percentage return to the management of Mitchell Labs from the restructuring? Use answers from parts a and b to determine this value

The trustee in the bankruptcy settlement for Titanic Boat Co. lists the following book values and liquidation values for the assets of the corporation. Liabilities and stockholders’ claims are also shown.

Assets

Book value

Liquidation value

Accounts receivables

\(1,400,000

\)1,200,000

Inventory

\(1,800,000

\)900,000

Machinery and equipment

\(1,100,000

\)600,000

Building and plant

\(4,200,000

\)2,500,000

Total assets

\(8,500,000

\)5,200,000

Liabilities and stockholder’s claims

Liabilities

Accounts payable

\(2,800,000

First lien, secured by machinery and equipment

\)900,000

Senior unsecured debt

\(2,200,000

Subordinated debenture

\)1,700,000

Total liabilities

\(7,600,000

Stockholder’s claims

Preferred stock

\)250,000

Common stock

\(650,000

Total stockholder’s claims

\)900,000

Total liabilities and stockholder’s claims

$8,500,000

d. After the machinery and equipment are sold to partially cover the first lien secured claim, how much will be available from the remaining asset liquidation values to cover unsatisfied secured claims and unsecured debt?

Midland Corporation has a net income of \(19 million and 4 million shares outstanding. Its common stock is currently selling for \)48 per share. Midland plans to sell common stock to set up a major new production facility with a net cost of \(21,120,000. The production facility will not produce a profit for one year, and then it is expected to earn a 13 percent return on the investment. Stanley Morgan and Co., an investment banking firm, plans to sell the issue to the public for \)44 per share with a spread of 4 percent.

c. What are the earnings per share (EPS) and the price-earnings ratio before the issue (based on a stock price of $48)? What will be the price per share immediately after the sale of stock if the P/E stays constant?

What are the disadvantages to being public?
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