| Question 4 FIN4801 JANUARY/FEBRUARY 2018 |
| Bricks Ltd wants to expand its operations, as 11 Is experiencing rapid growth The company needs to obtain another furnace urgently In order to meet increased demand In purchasing the furnace It wants, 11 has negotiated financing with a before-tax cost of 13% interest per annum and the capital amount being repaid In full only at the end of the loan period Alternatively, the company can enter into a direct f1nanc1al lease with the manufacturer of the machine, which means that the manufacturer will offer the machine and maintenance on it for the useful life of the machine at a cost
The machine costs R500 000 and it Is expected that it will require maintenance of R50 000 per year, if bought it is also expected that the machine can be sold for R100 000 at the end of its useful life of five years. The machine can be depreciated by way of the straight-line method over a period of five years. The lease will cost R125 000 per year, paid at the end of every year for five years. A tax rate of 28% Is applicable. The company has a before-tax cost of debt of 13%. Required: Determine the net advantage of leasing and advise the company on the option they should take based on your findings. |
| List of the Concepts | Workings |
| Before tax Cost of borrowing 13%.
1. Capex R500 000. 2. Maintenance Cost R50 000. 3. Residual Value R100 000. 4. Useful life 5 years. 5. Depreciation straight line Method for 5 years. 6. Lease Payments R125 000 7. Tax Rate 28% |
After Tax-Cost of borrowing
13(1-tax) = 13(1-0.28%) = 13(0.72) = 9.36 Depreciation per year = (R500 000)/5 = R100 000 Tax Saving on Depreciation R100 000*0.28%= R28 000 per year. Foregone Tax Savings on Maintenance = R50 000*0.28% = R14 000 Tax on Residual Value = 100 000*0.28=28 000 |
| Description | 0 | 1 | 2 | 3 | 4 | 5 |
| PV of loan Avoided | 500 000 | |||||
| Lease Payment | (125 000) | (125 000) | (125 000) | (125 000) | (125 000) | |
| Tax Savings on Lease@28% | 35 000 | 35 000 | 35 000 | 35 000 | 35 000 | |
| Maintenance Cost | 50 000 | 50 000 | 50 000 | 50 000 | 50 000 | |
| Foregone Tax Savings on Maintenance | (14 000) | (14 000) | (14 000) | (14 000) | (14 000) | |
| Depreciation Tax Saving | (28 000) | (28 000) | (28 000) | (28 000) | (28 000) | |
| Residual Value | (100 000) | |||||
| Tax on Residual Value | 28 000 | |||||
| Net Cash Flow | 500 000 | (82 000) | (82 000) | (82 000) | (82 000) | (154 000) |
| Discount Factor @9.36% | 1.000 | 0.9144 | 0.8361 | 0.7646 | 0.6991 | 0.6393 |
| 500 000 | (74 981) | (68 560) | (62 697) | (57 326) | (98 452) | |
| 137 984 | ||||||
| Description Buy Option | 0 | 1 | 2 | 3 | 4 | 5 |
| Capex | 500 000 | |||||
| Maintenance Cost | 50 000 | 50 000 | 50 000 | 50 000 | 50 000 | |
| Foregone Tax Savings on Maintenance | (14 000) | (14 000) | (14 000) | (14 000) | (14 000) | |
| Depreciation Tax Saving | (28 000) | (28 000) | (28 000) | (28 000) | (28 000) | |
| Residual Value | (100 000) | |||||
| Tax on Residual Value | 28 000 | |||||
| Net Cash Flow | 500 000 | 8,000 | 8,000 | 8,000 | 8,000 | (64 000) |
| Discount Factor @9.36% | 1.000 | 0.9144 | 0.8361 | 0.7646 | 0.6991 | 0.6393 |
| 500 000 | 7,315 | 6,689 | 6,117 | 5,593 | (40,915) | |
| 484,799 | ||||||
| Description Lease Option | 0 | 1 | 2 | 3 | 4 | 5 |
| Lease Installments | (125 000) | (125 000) | (125 000) | (125 000) | (125 000) | |
| Tax Benefits on Lease Payments | 35 000 | 35 000 | 35 000 | 35 000 | 35 000 | |
| Net Cash Flow | (90 000) | (90 000) | (90 000) | (90 000) | (90 000) | |
| Discount Factors @9.36% | 1.000 | 0.9144 | 0.8361 | 0.7646 | 0.6991 | 0.6393 |
| (82,296) | (75,249) | (68,814) | (62,919) | (57,537) | ||
| (346,815) |