Question

WHC will need to purchase additional necessary equipment, which will cost $77 million. To get the equipment in running order, there would be a $2 million shipping fee and a $3 million installation charge. The equipment will be depreciated to zero on a straight-line basis over its economic life of 15 years. The contract runs for only eight years. At that time the coal from the site will be entirely mined. The company feels that the equipment can be sold for 10 percent of its initial purchase price in eight years.

Instead of purchasing the equipment, your team, being experienced consultants, wishes to propose to WHC that they have another option which is leasing it. Coincidently, your other client, Resolute Leasing Limited (RLL), may be a suitable lessor. On discussions, the executives at RLL have asked you to prepare a lease quotation that could be forwarded to WHC for consideration.

For the purpose, RLL has provided the following information: • RLL can get a 20% discount on the purchase price of the machinery.

• They expect the life of the machinery to be 15 years with a salvage value of $5 million after that. WHC may use this machinery for eight years, and RLL is confident that it can be leased to others after that.

• RLL uses the straight-line method for calculating depreciation.

• As the owner of the machinery, RLL is responsible for its annual maintenance cost.

• RLL’s effective tax rate is 10%

(i) If the RLL’s after-tax required rate of return is 10% per annum, what will be the minimum annual lease payment that RLL would charge? Consider that RLL requires lease payments to be made annually in advance. (8 marks).

(ii) Calculate the maximum annual lease payment that would make leasing a viable option for WHC?

Answer 1

Part 1

Minimum annual lease payment that RLL would charge

Given,

- RLL’s after-tax required rate of return is 10% per annum

Cost of necessary equipment
Purchase cost	7,70,00,000
Less: 20% Discount	-1,54,00,000
Net Purchase Cost	6,16,00,000
Add: Shipping Fee	20,00,000
Add: Installation Charge	30,00,000
Total Cost	6,66,00,000

Particulars	Year 0	Year 1 - 14	Year 15
Total Equipement Cost (Outflow)	6,66,00,000.00	-	-
Expenses
Depreciation for 15 Years (Zero residual) (SLM) (A)	-	-64,93,333.33	-64,93,333.33
Salvage value (B)	-	-	50,00,000.00
Total Expenses (A) + (B)	-	-64,93,333.33	-14,93,333.33
Saving in Tax @ 10% (C)	-	6,49,333.33	1,49,333.33
Total Cash inflow (B) + (C)	-	6,49,333.33	51,49,333.33
PVAF @ 10%		7.3667	0.2394
Total Cash Flow		47,83,435.72	12,32,709.46
Total Outflow	6,66,00,000.00
Total Present Value of Inflow	-60,16,145.18
Net Outflow	6,05,83,854.82
Installments are in advance
Consider PVAF for 14 Years + 1 Year (for advance)
PVAF @ 10% for 14 Years	7.3667
PVAF @ 10% for 0 Year	1.0000
	8.3667
Installment Before Tax Effect	72,41,080.19
Installment After Tax Effect @ 10%	80,45,644.66

Final Minimum Annual Instalment: $80,45,644.66 + Annual Maintenance Cost

Part 2:

Given,
- RLL’s after-tax required rate of return is 10% per annum
Rate of return before Tax	11.00%

Cost of necessary equipment
Purchase cost	7,70,00,000
Less: Discount	-
Net Purchase Cost	7,70,00,000
Add: Shipping Fee	20,00,000
Add: Installation Charge	30,00,000
Total Cost	8,20,00,000

Particulars	Year 0	Year 1 - 7	Year 8
Total Equipement Cost (Outflow)	8,20,00,000.00	-	-
Expenses
Depreciation for 15 Years (Zero residual) (SLM) (A)	-	-64,93,333.33	-64,93,333.33
Loss on sale of Assets (WDV - Sales) (B)	-	-	-2,23,53,333.33
Total Expenses (A) + (B)	-	-64,93,333.33	-2,88,46,666.67
Saving in Tax @ 10% (C)	-	6,49,333.33	28,84,666.67
Cash Inflow on Sale of Assets @ 10% of Value	-	-	77,00,000.00
Total Cash inflow (B) + (C)	-	6,49,333.33	1,05,84,666.67
PVAF @ 11%		4.7122	0.4339
Total Cash Flow		30,59,786.11	45,92,967.32
Total Outflow	8,20,00,000.00
Total Present Value of Inflow	-76,52,753.43
Net Outflow	7,43,47,246.57
Installments are in advance
Consider PVAF for 7 Years + 1 Year (for advance)
PVAF @ 10% for 7 Years	4.7122
PVAF @ 10% for 0 Year	1.0000
	5.7122
Installment	1,30,15,527.33

Maximum Instalment = $1,30,15,527.33 + Annual Maintenance Cost