sunset healthcare is planning to acquire a new x-ray machine that cost $200,000. The business can either lease the machine using an operating lease or buy it using a loan from a local bank. Suncoast’s balance sheet prior to acquiring the machine is a follows:

current assets $100,000 debt $400,000

net fixed assets 900,000 equity 600,000

total assets $1,000,000 total claims $1,000,000

a. what is suncoast’s current debt ratio.

b. what would the new debt ratio be if the machine were leased?. If it is purchased.

c. is the financial risk of the business different under the two acquisition alternatives.

18.2. big sky hospital plans to obtain a new MRI that cost $1.5 million and has an estimated four-year useful life. It can obtain a bank loan for the entire amount and buy the MRI, or it can lease the equipment . Assume that the following facts apply to the decisions:

the MRI falls into the three year class for tax depreciations so the MACRS allowances are 0.33, 0.45,0.15, and 0.7 in years 1 through 4 respectively.

estimated maintenance expenses are $75,000 payable at the beginning of each year whether the MRI is leased or purchased.

big sky marginal tax rate is 40 percent.

the bank loan would have interest rate of 15 percent.

if leased, the lease ( rental ) payments would be $400,000 payable at the end of each of the next for years.

the estimated residual ( and salvage) value is $250,000.

a. what are the Nal and IRR of the lease? interpret each value?.

b. assume now that the salvage value estimate is $300,000 but all other facts remain the same. What is the new Nal? the new IRR?

18.3 Healthplan northwest must install a new $1million computer to track patients records in its three service areas. It plans to use the computer for only three years, at which time a brand new system will be acquired that will handle both billing and patient records. The company can obtain a 10 percent bank loan to buy the computer, or it can lease the computer for three years. Assume that the following facts apply to the decision.

the computer falls into the three year class for tax depreciation, so the MACRS allowances are 0.33, 0.45,0.15,and 0.07 in years 1 through 4, respectively.

the company’s marginal tax rate is 34 percent.

tentative lease terms call for payments of $320,000 at the end of year.

the best estimate for the value of the computer after three years of wear and tear is $200,000.

a. what are the NAL and IRR of the lease? interpret each value.

b. assume now that the bank loan would cost 15 percent, but all other facts remain the same. What is the new NAL? The new IRR.?

18.4 Assume that you have been asked to place a value on the ownership position in briarwood hospital, It’s projected profit and loss statements and equity reinvestment ( asset) requirement are as follows ( in millions):

2012 2013 2014 2015 2016

net revenues $225.0 $240.0 $250.0 $260.0 $275.0

cash expenses 200.0 205.0 210.0 215.0 225.0

depreciation 11.0 12.0 13.0 14.0 15.0

earnings before interest and taxes(EBT) 14.0 $23.0 $27.0 $31.0 $35.0

interest.

earning before taxes (EBT) 8.0 9.0 9.0 10.0 10.0

taxes (40 percent) 6.0 14.0 8.0 21.0 25.0 2.4 5.6 7.2 8.4 10.0

net profit 3.6 8.4 10.8 12.6 15.0

asset requirement 6.0 6.0 6.0 6.0 6.0

briar woods cost of equity is 16 percent. the best estimate for briar wood long term growth rate is 4 percent.

a. what is the equity value of the hospital

b. suppose that the expected long term rate was 6 percent. what impact would this change have on the equity value of the business? What if the growth rate were only 2 percent?

Project description

Sunset healthcare is planning to acquire a new x-ray machine that cost $200,000. The business can either lease the machine using an operating lease or buy it using a loan from a local bank. Suncoast’s balance sheet prior to acquiring the machine is a follows:

current assets $100,000 debt $400,000

net fixed assets 900,000 equity 600,000

total assets $1,000,000 total claims $1,000,000

a. what is suncoast’s current debt ratio.

b. what would the new debt ratio be if the machine were leased?. If it is purchased.

c. is the financial risk of the business different under the two acquisition alternatives.

Answer

Current debt ratio = Total debt/Total assets = $400,000/$1,000,000 = 0.40 = 40.0%.

Assuming the new machine was leased, it would be listed in the footnotes rather than on the face of the balance. Therefore, the debt ratio would not change from 40%.

If the machine was purchased, the total debt would increase to $ 600,000 and the total assets would rise to $1,200,000. Therefore, the debt ratio would go up to $ 50% (600,000/1,200,000).

In excel:

Current Assets

100,000

Debt

600,000

Net Fixed Assets

1,100,000

Equity

600,000

Total Assets

1,200,000

Total Claims

1,200,000

Debt Ratio

50% = 30/32

Under the two alternatives, the financial risk would not be different. Both leasing and debt financing necessitate the business to incessantly pledge series of cash payments. Given that a non-payment occurs, the business would possibly opt for the machine to be taken back whether purchased or leased. Lastly, both lessor and creditor would be able to compel the business into bankruptcy if need be.

18.2. Big sky hospital plans to obtain a new MRI that cost $1.5 million and has an estimated four-year useful life. It can obtain a bank loan for the entire amount and buy the MRI, or it can lease the equipment. Assume that the following facts apply to the decisions:

the MRI falls into the three year class for tax depreciations so the MACRS allowances are 0.33, 0.45,0.15, and 0.7 in years 1 through 4 respectively. estimated maintenance expenses are $75,000 payable at the beginning of each year whether the MRI is leased or purchased.

big sky marginal tax rate is 40 percent.

the bank loan would have interest rate of 15 percent.

if leased, the lease ( rental ) payments would be $400,000 payable at the end of each of the next for years.

the estimated residual ( and salvage) value is $250,000.

a. what are the Nal and IRR of the lease? interpret each value?.

ANSWER.

Before-tax cost of debt

15%

Tax rate

40%

After-tax cost of debt

9%

Year 1

Year 2

Year 3

Year 4

33%

45%

15%

7%

The following are the net cash flows linked to owning:

Year 0

Year 1

Year 2

Year 3

Year 4

Cost of owning

Net purchase price

-$1,500,000

Maintenance cost

-$75,000

-$75,000

-$75,000

-$75,000

-$75,000

Maintenance tax savings

$30,000

$30,000

$30,000

$30,000

$30,000

Depreciation tax savings

$198,000

270,000

90;000

42,000

Residual value

$250,000

Tax on residual value

-$100,000

-$1,545,000

$153,000

$225,000

$45,000

$192,000

Depreciation tax savings

Year 1 = C25*E26*-D33

Year 2 = C25*F26*-D33

Year 3 = C25*G26*-D33

Year 4 = C25*H26*-D33

Tax on residual value = ((-D33*(I-E26-F26-G26-H26))-H37)*C25

The net cash flows related with leasing are as follows.

A

B

C

D

E

F

G

H

I

51

Cost of leasing

52

Lease payment

-400000

-400000

-400000

-400000

53

Lease tax savings

160000

160000

160000

160000

54

Maintenance cost

-75000

-75000

-75000

-75000

55

Maintenance tax savings

30000

30000

30000

30000

56

Net cash flows

-45000

-285000

-285000

-285000

-240000

57

If Big Sky leases the MRL, there would be a $108,048 increase on the equity value of the business; hence the asset would be leased.

Net advantage to leasing

PV cost of leasing ($936441) = NPV (C26, E56:H56) +D56

PV cost of owning ($1,044,489) = NPV (C26, E39:H39) +D39

NAL $108,048 = D62-D63

IRR of the lease contract is here, which is the after-tax cost of lease. Since the after-tax cost of the loan is 15 percent *0.6 = 9 percent, the lease is cheaper than buying and borrowing. Therefore, both IRR and NAL offer that the leasing is better than buying.

A

B

C

D

E

F

G

H

70

Internal rate of return of the lease:

71

Leasing cash flow

-45,000

-285000

-285000

-285000

-240000

72

Owning cash flow

-1,545,000

153000

225000

45000

192000

73

Incremental cash flow

1,500,000

-438,000

-510,000

-330,000

-432,000

74

IRR

5.6%

=IRR(D73:H73)

assume now that the salvage value estimate is $300,000 but all other facts remain the same. What is the new Nal? The new IRR?

If the same analysis is done with a salvage of $ 300,000, the NAL is decreased to $86,795 from $108,048. This means that an increase in salvage value leads to a lower NAL. With a $300,000 salvage value, the after-tax cost of the lease rises to 6.3%. An increase in salvage value makes leasing appealing, therefore increasing its after-tax cost effectiveness (Helfert, 2001)…………………………………..

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