Question

Anderson plans to acquire an automated assembly line with ten year life at a cost of sh 10 million, delivered and installed. He plans to use the equipment for only five years.He can borrow the required 10 million at a before cost of 10%.The estimated scrap value is sh 50,000 after ten years, but its estimated scrap value after five years is sh 1 million.He can lease the equipment for 5 years at a rental charge of sh 2.75m payable at the beginning of each year.The lessor will maintain the equipment. However if he buys he will bear the cost of maintenance of shs500,000 per year payable at the beginning of the year.The marginal tax rate is 40%

Analyze whether the company should purchase or lease the asset(

Answer 1

leasing decision:-

buying decision:-

advantages of buying is tax on interest and depreciation can be claimed.

hence nothing was mentioned about repayment schedule lets assume paid in equal annual investments.

annuity factor for 10% for 5years = 3.79

Equal annual installment = 10million / 3.79 = 2.638million

interest calculation:-

yr opening balance installement interest adjusted for principal balance outstanding

1. 10million 2.638million 1million 1.638million 8.362million

2. 8.362million 2.638million 0.8362million 1.8018million 6.5602million

3. 6.5602million 2.638million 0.65602million 1.98198million 4.57million

4. 4.57million 2.638million 0.457million 2.181million 2.389million

5. 2.389million 2.638million 0.2389million 2.389million -

Determining net interest:-

year interest tax(40%) net interest

1 1million 0.4million 0.6million

2. 0.8362million 0.33448million 0.50172million

3. 0.65602million 0.262408million 0.393612million

4. 0.457million 0.1828million 0.2742million

5. 0.2389million 0.09556million 0.14334million

depreciation:-

10million - 1million / 5 = 1.8million (cost less scrap value / no..of years)

tax saving on depreciation per year = 0.72million (1.8*40%)

maintenance cost:-

tax saving on maintenance cost = 0.5million * 40% = 0.2million

net outflow

year principalpaid net interest maintenancecost depreciationsaving netcost DF P.V.O.F.  

0 - - 0.5million - 0.5million 1 0.5million

1 1.638million 0.6million 0.3million (0.72million) 1.82million 0.94 1.71million    

2 1.8018million 0.51million 0.3million (0.72million) 1.89million 0.89 1.68million

3. 1.9818million 0.4million 0.3million (0.72million) 1.96million0.84 1.65million

4. 2.181million 0.27million 0.3million (0.72million) 2.03million 0.79 1.60million

5. 2.389million 0.14million -    (0.72million) 1.81million 0.75 1.35million

total = 8.49million

less:- scrap value received 1million*0.75 (0.75million)

net   7.74million

leasing option:-

tax saving on rent:- 2.75m*40% = 1.1million

year rent taxsaving DF PV

0 2.75million 0 1 2.75million

1 2.75million 1.1million 0.94 1.55million

2 2.75million 1.1million 0.89 1.46852million

3. 2.75million 1.1million 0.84 1.386million

4. 2.75million 1.1million 0.79 1.303million

5. - 1.1million 0.75 (0.75million)  

Total = 7.71million

when compared to both leasing option is good.

note:-

1.assumption taken loan settled in 5years. if taken for 10years answer might change.

2. after tax cash flows should be discounted only with after tax discounted rate hence 10%(1 -40%) i.e. 60%used.

3. for maintenance cost and rents paid in beginning of the year. the tax for the same will be recovered only at the year end hence net of tax is taking accordingly. i.e. 0year tax benefit in year1.