Daniel Lewis Jewellers (DLJ) has conducted an evaluation of a number of different diamond polishers to replace its old diamond polisher which is no longer producing an adequate shine to their large range of diamond jewellery they hold in their exclusive jewellery store. Through a rigorous NPV analysis using a required rate of return of 12% p.a. and a 30% company tax rate, DLJ has decided to go with the Royal 1800. This diamond polisher looks ideal and has great cash flow benefits including a high NPV.
The diamond polisher costs $245,000 and is expected to last five years before it will require replacement. Royal Limited in conjunction with PacWest Bank has offered DLJ a great lease deal. DLJ’s latest loan was negotiated at 8.5% pa. If DLJ was to finance the Royal 100 by debt, it would be at this rate. The lease calls for five payments of $55,000 to be paid each year in advance. In addition the lease has a residual value payable at the end of the lease (year 5) of $80,000. DLJ expect to be able to sell the diamond polisher to a less prestigious jewellery store at the end of year 5 for $50,000. The tax depreciation for this type of equipment is seven years straight line. DLJ needs to determine if it should lease or buy the diamond polishing equipment. TO help make the decision, you are required to answer the following:
a) What are the cash flows from leasing?
b) What are the cash flows from buying?
c) What are the incremental cash flows to be used in lease versus buy decision?
d) What discount rate should DLJ use in the lease versus buy evaluation?
e) How should DLJ finance the equipment?
Need a model answer for these and also the method to finding the Tax for sale of the machine for both leasing and buying.