Rock Creek offers a truly unique golfing venue in the southern region of Alabama...

A case analysis by Lanot, Maceres, Martin & Pedrena

COMPANY BACKGROUND
- Public Golf Course owned by a private corporation - Lee Jeffries is the Club Manager. - The club has been using 40 battery-powered carts for five years.

CASE BACKGROUND
The carts they owned were old and: - Fully-depreciated - Being bought at $200 cash for each. Two salespersons offered Jeffries 40 new gasoline-powered carts.

Salesman A Proposal: - Sell carts at $2,240 each and - Expected Salvage Value = $240 each after 5 years.

Salesman B Proposal: - Lease the golf carts for $500 per cart per year. - Payable at the end of the year for five years. - Contract could be cancelled at any time with 90 days notice. Either case: - Out-of-pocket operating cost is $420 per cart per year. - Annual revenue from renting the carts is $84,000 for the fleet.

JEFFRIES ANALYSIS:
Go for purchasing the carts outright because

- If purchased outright: - Carts will pay for themselves in less than 2 years, even ignoring salvage value. - If leased: - Carts will cost $2500 each (which is higher than $2240) - RCGC will not get salvage proceeds.

DIRECTOR S REACTION
Not clear which is the better alternative even ignoring inflation, spending $2240 now may not be better than spending $500 over the next five years - If purchased outright: - Company will have to borrow funds at 8% interest cost. - Effective interest cost is actually lower due to 34 cents saving on taxes for every dollar of interest expense. - Lease payments are also tax deductable.

QUESTION # 1
Assume that in order to purchase the carts, RCGC would have to borrow $89600 at 8% interest for 5 years, repayable in 5 equal year end installments. Prepare an amortization schedule for this loan, showing how much of each year's payment is for interest and how much is applied to pay principal.

ANSWER TO Q # 1
Amortization Schedule for the loan
Amount Rate Term $ 89,600.00 8% 5 yrs PV factor (5yrs, 8%) = 3.993 Annual Installment = $ 22,439.27

Bal. of Year

Equal

Interest Portion of Payment

Reduction of Principal

Ending Balance of Principal

Principal Annual @beg. of yr. Payment $ $ $ $ $ $ 89,600 89,600 $ 22,440 $ 74,328 $ 22,440 $ 57,834 $ 22,440 $ 40,020 $ 22,440 $ 20,781 $ 22,440 $

0 1 2 3 4 5

7,168 $ 15,272 $ 5,946 $ 16,494 $ 4,626 $ 17,814 $ 3,201 $ 19,239 $ 1,662 $ 20,778 $

74,328 57,834 40,020 20,781 3

QUESTION # 2
Assume salesperson B's company also would be willing to sell the carts outright at $2,240 per cart. Given the proposed lease terms, and assuming the lease is outstanding for 5 years, what interest rate is implicit in the lease? (Ignore tax impacts to the leasing company when calculating this implicit rate.) Why is this implicit rate different from the 8% that RCGC may have to pay to borrow the funds needed to purchase the carts.

ANSWER TO Q # 2
PV = PMT * [ PV factor for n = 5 years; i = ?? per year ] $2,240 = $500 * [ PVOA factor for n = 5 years; i = ?? per year ] $2,240 / $500 = [ PVOA factor for n = 5 years; i = ?? per year ] 4.48 = [ PVOA factor for n = 5 years; i = ?? per year ]

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ANSWER TO Q # 2
PV = PMT * [ PV factor for n = 5 years; i = ?? per year ] $2,240 = $500 * [ PVOA factor for n = 5 years; i = ?? per year ] $2,240 / $500 = [ PVOA factor for n = 5 years; i = ?? per year ] 4.48 = [ PVOA factor for n = 5 years; i = ?? per year ] 4.48 = PVOA factor for n = 5 years; i

= 4% per year

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ANSWER TO Q # 2
PV = PMT * [ PV factor for n = 5 years; i = ?? per year ] $2,240 = $500 * [ PVOA factor for n = 5 years; i = ?? per year ] $2,240 / $500 = [ PVOA factor for n = 5 years; i = ?? per year ] 4.48 = [ PVOA factor for n = 5 years; i = ?? per year ] 4.48 = PVOA factor for n = 5 years; i

= 4% per year

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QUESTION # 3
Should RCGC buy the carts from A, or lease them from B? (Assume that if the carts are purchased, RCGC will use accelerated depreciation for income tax purposes, based on an estimated life of 5 years and an estimated residual value of $240 per cart. The accelerated depreciation percentages for years 1-5, respectively are 35%, 26%, 15.6%, 11.7%, and 11.7%)

Capital Budgeting Decision

ANSWER TO Q # 3

$ 89,600.00 $ 9,600.00
After-tax Discou Interest Depreciation EBT Tax inflow nt d e f = c - (d + e) g = f * 34% h = c - g Factor NPV $ (81,600.00) 32,032.00 40,454.00 50,094.00 54,639.00 65,778.00 10,890.88 56,309.12 13,754.36 53,445.64 17,031.96 50,168.04 8,577.26 48,622.74 0.926 $ 52,142.25 0.857 $ 45,802.91 0.794 $ 39,833.42 0.735 $ 35,737.71 0.681 $ 37,070.56 $ 128,986.86

22,364.52 54,435.48

Proposal B: Lease the carts @ $500 per cart per year

Annual Lease Payments $ 20,000.00 $ 36,800.00 Annual Pre-tax nte inflow $ 47,200.00 Tax (34% * $47,200) $ 16,048.00 Annual After Tax inflow $ 31,152.00 Discount Factor for 8%, 5yrs (Table A) 3.993 Net present value (NPV) $ 124,389.94

Proposal A Proposal B

$ $

128,986.86 124,389.94

Answer: Buy the carts from A

QUESTION # 4
Assume arbitrarily that purchasing the carts has an NPV that is $4000 higher than the NPV of leasing them. How much would B have to reduce the proposed annual lease payment to make leasing as attractive as purchasing the cart?

ANSWER TO Q # 4
Checking: Proposal: Expected Annual Revenue 84,000.00 Annual Out-of-pocket Oper. Exp. 16,800.00 Annual Lease 20,000.00 36,800.00 Payments Annual Pre-tax nte inflow 47,200.00 Tax (34% * $47,200) 16,048.00 Annual After Tax inflow Discount Factor for 8%, 5yrs (Table A) Net present value (NPV) Expected Annual Revenue 84,000.00 31,152.00 3.993 124,389.94

Solution:
Differential NPV $ 4,000.00 Discount Factor for 8%, 3.993 5yrs (Table A) Differential Annual $ 1,001.75 After Inflow Tax rate 34% Differential Annual $ 1,517.81 Pre-tax Inflow Divide by No. of carts 40 Incremental decrease in lease payts $ 37.95

Annual Out-of-pocket Oper. Exp. 16,800.00 Annual Lease 18,482.00 35,282.00 Payments Annual Pre-tax nte inflow 48,718.00 Tax (34% * $47,200) 16,564.12 Annual After Tax inflow Discount Factor for 8%, 5yrs (Table A) Net present value (NPV) 32,153.88 3.993 128,390.44 4,000.51

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