Question

Bad Boys Sports Limited (BBS) is a leading manufacturer of highperformance alloy wheels for professional motorsport teams and street racing fanatics worldwide. The products of BBS include standard cast one-piece wheels and special forged one-piece wheels. Due to keen competition and technological advancement in wheels manufacturing, the company intends to develop the multi-piece forged wheels line. The chairman of the Board believes that the new product line not only allows BBS to maintain its leading position in alloy wheel manufacturing in the coming decade but will also improve the existing production capacity by eighty per cent in the next four years. To implement the new product line, BBS needs to raise $20 million in funds to finance the procurement of a direct numerical control (DNC) machine. After carefully studying all financing alternatives, the finance director has reduced the financing possibilities into two options: (1) a financial lease and (2) a bank loan with attached warrants. Information on the two financing alternatives is as follows: 1 Financial lease The DNC machine, with a value of $20 million, can be leased from Kowloon Capital. Under the terms of the lease agreement, BBS is required to pay $5,500,000 in end-of-year annual payments to Kowloon Capital over the next four years. The lessor will pay all services and maintenance costs while the lessee will bear insurance and other costs. Upon termination of the lease at the end of the fourth year, BBS will exercise the purchase option and acquire the machine for $2,000,000. 2 Bank loan with attached warrants Besides the above financial lease option, BBS can borrow a four-year loan of S20 million from New Territory Bank. The interest rate for this loan is 9%p.a., and the firm is required to pay a $6,100,000 end-of-year payment over the next four years. In addition to the annual payment, the facility letter stated that BBS needs to issue 2,000,000 units of warrants to New Territory Bank. Each warrant allows the Bank to purchase one share of BBS's stock for $13 per share at any time during the next four years. The current stock price of BBS is $11 per share, and the market value of one BBS warrant is worth $0.24, estimated by the Bank. The combined market value of the debt and the attached warrants equals the $20 million initial loan principal. In addition, the feasibility study revealed that the DNC machine has an expected life of four years with a 2 million residual value. After acquiring the DNC machine, BBS needs to spend $200,000 at the end of each year on service and maintenance. The estimated depreciation of the machine is allocated as $3,000,000 in the first year, $4,000,000 in the second year, $5,000,000 in the third year, and $6,000,000 in the fourth year. However, the company intends to keep the machine and operate it beyond its four years of useful life. BBS is in the 25% tax bracket, and its after-tax cost of debt is 6.75% under the debt with warrants alternative. As an analyst of the finance department, you are required to recommend to the finance director which of the financing alternatives - the financial lease or the bank loan with warrants - would provide the least burden on the firm's cash flows over the next four years. Based on the information provided in the case, answer the following questions: a For the lease alternative, use the spreadsheet and calculate:

i the after-tax cash outflows for each of the next four years; and
ii the present value of the cash outflows using the appropriate discount rate.

Answer 1

Under the lease alternative, the after-tax cash outflow for each of the next four years is calculated to be $4,125,000, and the present value of the cash outflows is $14,624,265.

Step-by-step explanation:

To calculate the after-tax cash outflows for each of the next four years under the lease alternative, we need to determine the annual payment and deduct any tax savings from it. In this case, the annual payment is $5,500,000. Since the lease payment is a tax-deductible expense, we can calculate the tax savings by multiplying the payment by the tax rate of 25%, which gives us $1,375,000. Therefore, the after-tax cash outflow for each year would be $5,500,000 - $1,375,000 = $4,125,000.

To calculate the present value of the cash outflows, we need to discount the future cash flows using the appropriate discount rate. Let's assume a discount rate of 8% for this calculation. We can use the formula PV = CF / (1 + r)^n, where PV is the present value, CF is the cash flow, r is the discount rate, and n is the number of periods. Plugging in the values, we get:

1. Year 1: PV = $4,125,000 / (1 + 0.08)^1 = $3,819,444
2. Year 2: PV = $4,125,000 / (1 + 0.08)^2 = $3,535,012
3. Year 3: PV = $4,125,000 / (1 + 0.08)^3 = $3,263,893
4. Year 4: PV = $4,125,000 / (1 + 0.08)^4 = $3,005,916

Therefore, the present value of the cash outflows over the next four years is $3,819,444 + $3,535,012 + $3,263,893 + $3,005,916 = $14,624,265.