America Coffee House Case Study Investment Decision Ms. Matthews is currently weighing her options for new refrigeration

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America Coffee House Case Study
Investment Decision
Ms. Matthews is currently weighing her options for new
refrigeration equipment she is considering for her expansion of
frozen yogurt offerings. This equipment would be important for
distribution and storage facilities to store yogurt before delivery
to retail operations. She is currently working out a deal with
Blizzard Inc.; a US ice cream manufacturer that is offering to
lease brand new equipment it has acquired to ACH. Ms. Matthews is
also considering just purchasing the equipment up front from the
original equipment manufacturer. She is trying to understand why
Blizzard Inc. would lease equipment to ACH, and what the benefits
and drawbacks of leasing would potentially have for ACH. She also
wants to know what type of lease is being considered, and what the
effects would be on ACH's statement of financial position. She
wants you to include this information in your report.
ACH is considering investing in new manufacturing equipment that
would cost $10M if purchased today from the original manufacturer.
The CCA rate applicable to this asset is 35%. Alternatively, ACH
could lease the equipment for $2.15M annually over a six year term,
with payments at the beginning of each year. The salvage value is
expected to be $1,500,000 at the end of six years, according to
ACH's CFO Justine Brown, and the disposal of the assets will not
trigger any tax effects. The applicable tax rate is 25%. At the end
of the lease, ACH has the option to purchase the equipment at a
bargain price.
Ms. Matthews wants your advice on whether or not ACH should
purchase or lease the asset. She wants you to determine the effect
of having payments at the end of the year, rather than at the
beginning of the year. She also believes that the salvage value
estimation by Justine Brown is incorrect, and that the salvage
value could be as high as $2.7M after six years. She wants to know
how a salvage value of $2.7M will impact the purchase or leasing
decision, when payments are either at the beginning or end of a
period. Blizzard Inc. has also offered to have lease payments at
the end of each period, as long as ACH puts up a $800K security
deposit. Ms. Matthews wants you to evaluate the impact of the
security deposit option.
Finally, Ms. Matthews wants to know what lease payment would
effectively lead to indifference between leasing and purchasing,
under the original offer (i.e., six payments at the beginning of
the year and a $1.5M salvage value).
After taking these scenarios into account, Ms. Matthews would
like you to recommend what ACH should ultimately do.
Weighted Average Cost of Capital (WACC)
Ms. Matthews wants you to use the weighted average cost of
capital (WACC) as the required return. ACH currently has 10 million
common shares that are trading at $30 per share. The dividend is
expected to increase to $3.00 per share in the next period. ACH
also has 1 million preferred shares that get $1M in dividends and
are currently trading at $20 per share. Ms. Matthews wants you to
determine the cost of preferred equity and common equity, using
dividends and share prices. The anticipated constant growth rate
for common dividends is 2%.
The total market value of debt ACH expects to have going into
this investment is $120M. The before-tax cost of debt is
approximately 8%, excluding the impact of re-financing at a lower
rate of 6% for $50M. Ms. Matthews wants you to use the 8% interest
rate as the proxy for the cost of debt, but needs you to determine
the after-tax cost of debt to be used in the WACC.
A tax rate of 25% has been suggested for use in the analysis.WACC
rate is
your Net Advantage to Leasing analysis of the investment using
the WACC as the discount rate. In addition, determine the impacts
of the sensitivity analysis in the case, including