Prudent Solutions

8 August 2016

The Data Acquisition System (DAS) is initially estimated to cost $41. 25 million if purchased outright. This purchase can be done using currently invested short-term marketable securities. Leasing is also an option with payments estimated at $12. 75 million per year. After analyzing each scenario using the discounted cash flow method, the best option is to lease the equipment rather than purchase it. The net present value (NPV) for leasing the DAS is a negative ($28. 10 million) and the NPV for the purchasing the DAS is a negative ($28. 64 million). Our net advantage for leasing is $0.543 million. Summary of Facts: We have developed a new process that makes spent nuclear rods inert rendering them harmless. R&D is complete and we are now moving to commercial production of the process in house. As part of the production equipment a sophisticated Data Acquisition System (DAS) is needed to monitor the entire fuel conversion process to ensure the fuel is safe upon completion. The IRR for this project is estimated to be 24% and the project is judged to have low risk. Risk is based on after tax cost of capital of 11% for low risk, 13% for average risk, and 15% for high risk.

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The data acquisition system will only be utilized for 4 years regardless of whether it is purchased or leased. Statement of problems: Each of us in the decision making process have different views on how to acquire the DAS. Therefore, we need to address each of these problems and determine the best approach for acquiring the new data system. First, what discount rate should we use when evaluating the lease-versus-purchase decision? Should we use the firm’s WACC of 13 percent, or the firm’s rate on secured debt that reflects the lowest risk?

Second, we need to determine if it will be better to lease or purchase the new system? Analysis: Discount Rate We have determined that the cash flows generated in the lease-versus-purchase situation are more certain than are the cash flows generated by the firm’s average projects. Consequently, these cash flows should be discounted at a lower rate in order to reflect their lower risk. At the present time, the firm’s cost of secured debt carries the lowest risk rate of Prudent. Therefore, 10% should be used as the discount rate in the lease versus purchase decision. Prudent’s Analysis:

Purchase option: We have capital available now to purchase the DAS if we sell off tradable securities ($41. 25 million worth). However, this removes a possible revenue stream as the funds could be lent out instead. With the purchase, we get a maintenance contract that costs $2. 25 million per year. We expect to use the system for only 4 years (see Table 1). The system has an estimated 8 year life expectancy, after the 4 years, we expect to sell the system for a positive salvage value of $7. 0125 million or greater. If we choose to purchase the system It will cost $41. 25 Million to purchase.

The system will come with a maintenance contract that will cost Prudent $2. 25 million per year, payable at the first of each year. Tax wise, the system falls into MACRS 5 year tax area, with allowances of 0. 2, 0. 32, 0. 19, 0. 12, 0. 11, and 0. 06 in years 1 through 6 respectively. Prudent has sufficient capital to purchase the system. We have temporary investments in marketable securities that can pay for the equipment outright. This is the option already chosen if purchase is to take place. The equipment has a useful life expectancy of 8 years. Salvage value is expected to be book value or greater.

If we had chosen to pay with a loan the terms would be as follows, 4 year secured loan for $41. 25 million and an interest estimate of 10%. Lease option: Leasing costs can be spread out over the life of the lease at $12. 75 million per year. The maintenance contract on the equipment is included. With leasing, we get a payment tax savings of $5. 10 million per year given our 40% tax rate. After the 4 years, removal of the equipment is the Lessor’s job. We will have no residual value because the leased equipment will go back to the Lessor. If we choose to lease the system

Commercial Capital Corporation is the leasing subsidiary of a major regional bank and offers a lease at 12. 75 million per year for 4 years. The first payment is due upon delivery and installation. The rest of the payments are due each subsequent year at the beginning of the year. This cost includes the same service contract as what would have been obtained with purchase. Commercial Capital Corporation’s Analysis Commercial’s NPV is $. 1516 million (see Table 3). This was determined by using the present values of the four year lease agreement between Prudent and Commercial.

We concluded that Commercial’s discount rate will be 10% because of their opportunity cost. Commercial needs to have a residual value on the DAS of 6. 8 million or greater, which will give them a positive net present value. Therefore, if their net present value shows negative, they would not want to lease to us. Assuming Commercial receives the same 5 year MACRS rate on the equipment purchase, then the system should be worth 7. 01 million (book value) at the end of year 4 (see Table 4). This allows Commercial to have a positive NPV of $. 1516 million (see Table 4). Therefore, they would be willing to lease the DAS to us.

Recommendation: Although our calculation concluded that leasing has a negative net present value, it is still lower than purchasing the equipment outright. The net advantage for Prudent to lease equals $. 56 million in savings. This was calculated by taking the difference of the NPV’s of Table 1 and Table 2. Therefore, we feel that it is in the best interest of Prudent to lease the equipment. There are several advantages for Prudent to lease. First, Prudent will know the outflows of cash that will be used for the DAS, which will significantly reduce the firm’s specific risk.

Second, we will not have to worry about determining the residual value and selling it in the fourth year. Third, the company will be able to leave their temporary investments which otherwise would have to be sold to purchase the equipment. Finally, the equipment will only be needed for four years, the additional cost to purchase the system is not worth the four year investment. As a result, leasing is our best option. Appendix Table 1: Prudent Solutions, Inc. (lessee) Estimated Cash Flows for Purchasing (DAS) (In Millions of Dollars) Year 0Year 1Year 2Year 3Year 4 Equip cost($41. 25) Maintenance.

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