For Case III, below is the right answer, please revise ours accordingly. 1. It appears the decision to acquire the equipment and perform the image upgrade has already been made. As such, we can assume that we simply need to provide the best solution based on the total cost and/or annual cost of financing. Since the case occurs in current time and the CarMax beta is actual, we can assume today’s market conditions (i.e. Last year’s return on the market was an outlier as is this years; therefore, we would like to use a market return of 7% to find the risk premium). The DCF approach and the CAPM approach provide different costs of equity. SML derived returns need not be same as implied discount rates even when CAPM is applicable and markets are efficient. This is because the stock returns and discount rates will be same mathematically only when the discount rates are expected to remain constant over the forecast period. The single period return of CAPM changes every year as the market changes with economic conditions implying that the market discount rates are changing. When the implied discount rates are varying, the ex-ante returns will have no resemblance to the implied discount rate for the year in consideration. Additionally, the stock from this company is private and thus should be adjusted higher as investors would require a higher liquidity premium since the stock is not publicly traded. The method you submitted (averaging the DCF and the CAPM) is a reasonable method of determining the cost of equity. The assumptions I should make on leasing the equipment. First, the company has good credit (they will receive a favorable rate of 10%). The tax rate is given in the problem. Estimated maintenance expenses are $50,000 per year. Though they can finance for a longer period, they can lease for only 3 years. The tentative lease terms call for payments of $260,000 at the end of each year for 3 years. The lease is a guideline lease. The equipment falls into a MACRS 3-year class. Thompkins will want to buy the equipment at the end of the lease. It can purchase at fair market value. The best estimate of the market value is $200,000. Essentially, Section 179 of the IRS tax code allows businesses to deduct the full purchase price of qualifying equipment and/or software purchased or financed during the tax year. That means that if you buy (or lease) a piece of qualifying equipment, you can deduct the FULL PURCHASE PRICE from your gross income. It’s an incentive created by the U.S. government to encourage businesses to buy equipment and invest in themselves.
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