Friendly Food
...etter decision after considering the time value of money and the lower degree of risk. The purchasing option involves a large cash outflow at the beginning of the period under consideration, and tax advantages throughout plus a recovered residual value at the end. When discounted against the steady cash outflows during the period of the least, the net advantage of leasing is $4,010. This analysis is detailed in Exhibit 1a. 3. In the preceding calculations, we used the 7.2% after-tax low-risk cost of capital to discount the cash flows for the purchasing decision. This rate corresponds to the firm’s standard cost of capital for low-risk projects of 12% (of which this is one). Because the purchasing decision would be financed using the firm’s own money rather than borrowed money, using the firm’s cost of capital would be more appropriate than using a borrowing discount rate. In this instance, the two rates conveniently happen to be the same. The lease analysis uses 7.2% as an after-tax discount rate, representing the current rate at which Friendly borrows on 3-5 year secured loans. We are asked to conduct an analysis reflecting the higher risk of the residual. This is represented in Exhibit 1b. Because of the uncertainty in residual value, this portion of the cash flows is discounted back at the firm’s average after-tax cost of capital of 14%. This weights our analysis further in favor of leasing, increasing the net advantage of leasing from $4,010 to $16,990. 4. According to Friendly’s experience, the expected useful life of this equipment is 8 years, while the MACRS depreciation schedule assigns the equipment an economic life of 6 years. If Friendly were to use it for its full economic life of 6 years, our analysis shows there would be a slight advantage to leasing the equipment and purchasing it for its residual book value at the end of year 4 over purchasing it outright. The net advantage of leasing in this case is $4,000. The specifics of this analysis are detailed in Exhibit 2. 5a. According to the terms presented in the case, one of the stipulations of a financial lease has been met. At the end of the lease, Friendly may purchase the asset, but at a market price. There is no transfer of ownership during the time of the ...