Question 12.2: The incremental cash flows associated with an equipment acqu...
The incremental cash flows associated with an equipment acquisition would be $38,000 per year (estimated annual revenue from sale of product less cost of production excluding equipment cost). The equipment costs $90,000.
The Analysis
The firm normally uses the weighted average cost of capital (WACC) as its “hurdle rate” in investment analysis. The WACC is estimated to be 14 percent.
| Method of Financing | Cost | Weighted in Capital Structure |
Weighted Cost |
| Debt | 0.1 | 0.5 | 0.05 |
| Equity | 0.18 | 0.5 | 0.09 |
| 0.14 = WACC |
If we use 14 percent as the discount rate, the net present value analysis for acquiring the equipment is:
| time | Cash Flow | Present Value @ 14% | Present Value @ 14% |
| 0 | −$90,000 | 1 | −$90,000 |
| 1–3 | $38,000 | 2.3216 | $88,221 |
| Net present value @ 14% | = −$ 1,779 |
The net present value of acquiring the equipment is negative using the WACC as a discount rate. But, if we lease the equipment, the net present value is clearly positive at any discount rate since leasing provides an expected net benefit of $38,000 − $36,829 = $1,171 per year.
Using 14 percent, these benefits have a net present value of $2,719.
The Decision
This analysis would seem to indicate that the firm should reject the buy alternative, but that leasing is acceptable (leasing has a positive net present value with any positive rate of discount). But Example 12.1 already showed that if the equipment is acceptable, the firm should buy-borrow, not lease!