Question

Company, a pharmaceutical manufacturing unit, cannot afford to have any power outage as this would lead to loss of time and production shortages. While preparing their annual budget they have allocated 8000 OMR for the purchase of a high power diesel generator set. Owning the generator would demand proper maintenance of the generator also, which would cost the company 250 OMR in the first year. Subsequently the maintenance charges will increase at the rate of 10% every year due to wear and tear of the moving parts. Moreover, there will be no demand for second hand generators in the market and the company does not get any resale value for the generator if they wish to sell it at any point of time. Alternatively, a Diesel Generator could be arranged on lease from an equipment supplier for an annual lease amount of 1400 OMR and the company does not have to worry about the maintenance of the equipment as this would be taken care by the supplier itself.

a. Determine which of these two alternatives, outright purchase or leasing, would be economically beneficial for the company, if the money is valued at 8% per year. The company plans to use the generator for 8 years.

b. However, if the company policy wishes to purchase the equipment what factors do the company has to consider to justify their decision, even if the decision is not economical?

Answer 1

Answer:

a)

	Alternative I : Purchase of high power diesel generator set
Year	Particulars	PV factor @ 8%	Cash out flows (OMR)	Discounted cash outflows (PV factor*Discounted cash outflows)
0	Purchase of diesel generator today	1	8000	8000
1	Maintenance cost	0.9259	250.00	231.48
2	Maintenance cost	0.8573	275.00	235.77
3	Maintenance cost	0.7938	302.50	240.13
4	Maintenance cost	0.7350	332.75	244.58
5	Maintenance cost	0.6806	366.03	249.11
6	Maintenance cost	0.6302	402.63	253.72
7	Maintenance cost	0.5835	442.89	258.42
8	Maintenance cost	0.5403	487.18	263.21
		Total cash outflows	9976.43

	Alternative II : Lease from a supplier
Year	Particulars	PV factor @ 8%	Cash out flows (OMR)	Discounted cash outflows (PV factor*Discounted cash outflows)
1	Annual lease amount	0.9259	1400	1296.30
2	Annual lease amount	0.8573	1400	1200.27
3	Annual lease amount	0.7938	1400	1111.37
4	Annual lease amount	0.7350	1400	1029.04
5	Annual lease amount	0.6806	1400	952.82
6	Annual lease amount	0.6302	1400	882.24
7	Annual lease amount	0.5835	1400	816.89
8	Annual lease amount	0.5403	1400	756.38
		Total cash outflows	8045.29

Out of the two alternatives of purchasing and leasing, leasing the diesel generator from a supplier is econmomially beneficial for the company as the total outflows are lower in alternative II than alternative I.

b) Even if the decision to purchase is not economical for the company and if the company wishes to purchase the equipment, then the following factors are to be considered to justify the decision:

i) The company can sale generator as a scrap after the its life time.

ii) The generator can be shown in its books of accounts as an assest.

iii) The delays in getting maintenance services from the supplier can be avoided.

iv) Working capital will be lower in the future years.

v) The company has the power to exercise ownership rights.