Brandi Manufacturing Ltd. has decided to expand. To raise additional capital, the company is considering selling $300,000 of its present manufacturing equipment to an insurance company and leasing it back for eight years, which is the estimated useful life of the equipment. The equipment will have no residual value after eight years. The annual rent on the lease-back would be $54,000.
The equipment to be sold under the sale-and-lease-back arrangement is not all of the equipment owned by the company. The undepreciated capital cost of all of the company’s manufacturing equipment (class 43) was $800,000 at the end of the previous year. Of this $800,000, approximately $100,000 relates to the equipment that the company is thinking of selling.
The equipment that would be sold is used to manufacture a single specialized product.
The equipment generates annual pre-tax revenues of $60,000 and is expected to continue to do so in the future.
Brandi is interested in the sale-and-lease-back arrangement because it will enable the company to obtain $300,000 of immediate funds with a related annual payment of $54,000, which appears to be equivalent to a low rate of interest. Assume the company is subject to a corporate tax rate of 25%.The company considers 12% to be a reasonable after-tax rate of return.
Required:
1. If Anderson does not sell the equipment, how much cash flow will be generated, in net present value terms, from the ownership and operation of that equipment?
2. What rate of interest is reflected in the lease arrangement?
3. What net present value cash flow would be obtained as a result of the sale-and-leaseback arrangement?