HMG Corporation is a for-profit health-care provider that operates three hospitals. One of these hospitals, Metrohealth, plans to acquire new X-ray equipment. Management has already decided the equipment will be cost beneficial and will enhance the technology available in the outpatient diagnostic laboratory. Before Metrohealth prepares the requisition to corporate headquarters for the purchase, Paul Monden, Metrohealth's controller, has to prepare an analysis to compare financing alternatives.
The equipment is a Supraimage X-ray 400 machine priced at $$\$ 1,000,000$$, including shipping and installation; it would be delivered January 2, 2001. Under the tax regulations, this machine qualifies as "qualified technological equipment" with a five-year recovery period. It will be depreciated over five years for tax purposes using the double-declining balance method, with a switch to the straight-line method at a point in time to maximize the depreciation deduction. The machine will have no salvage value at the end of five years. The three financing alternatives Metrohealth is considering are described next.
1. Finance Internally: HMG Corporation would provide Metrohealth with the funds to purchase the equipment. The supplier would be paid on the day of delivery.
2. Finance with a Bank Loan: Metrohealth could obtain a bank loan to finance 90 percent of the equipment cost at 10 percent annual interest, with five annual payments of $$\$ 237,420$$ each due at the end of each year, with the first payment due on December 31, 2001. The loan amortization schedule is presented next.
Metrohealth would provide the remaining $$\$ 100,000$$, which would be paid on delivery.
$$
\begin{array}{crrrr}
\text { Year } & \begin{array}{c}
\text { Beginning } \\
\text { Balance }
\end{array} & \text { Payment } & \text { Interest } & \begin{array}{c}
\text { Principal } \\
\text { Reduction }
\end{array} \\
\hline 1 & \$ 900,000 & \$ 237,420 & \$ 90,000 & \$ 147,420 \\
2 & 752,580 & 237,420 & 75,258 & 162,162 \\
3 & 590,418 & 237,420 & 59,042 & 178,378 \\
4 & 412,040 & 237,420 & 41,204 & 196,216 \\
5 & 215,824 & 237,420 & 21,596 & 215,824
\end{array}
$$
3. Lease from a Lessor: The equipment could be leased from MedLeasing, with an initial payment of $$\$ 50,000$$ due on equipment delivery and five annual payments of $$\$ 220,000$$ each, commencing on December 31, 2001. At the option of the lessee, the equipment can be purchased at the fair market value at lease termination (the lessor is currently estimating a 30 percent salvage value).
The lease satisfies the requirements to be an operating lease for both FASB and income tax purposes. This means that all lease payments are deductible for tax purposes each year. Because of expected technological changes in medical equipment, Metrohealth would not plan to purchase the X-ray equipment at the end of the lease commitment.
Both HMG Corporation and Metrohealth have an effective income tax rate of 40 percent, an incremental borrowing rate of 10 percent, and an after-tax corporate hurdle rate of 12 percent. Income taxes are paid at the end of the year.
a. Prepare a present value analysis as of January 1,2001, of the expected aftertax cash flows for each of the three financing alternatives available to Metrohealth to acquire the new X-ray equipment. As part of your present value analysis, (1) justify the discount rates you used and (2) identify the financing alternative most advantageous to Metrohealth.
b. Discuss the qualitative factors Paul Monden should include for management consideration before a final decision is made regarding the financing of this new equipment.
(CMA adapted)