Question

BioChem 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 7000 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 225 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 1300 OMR and the company does not have to worry about the maintenance of the equipment as this would be taken care of 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 10% 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

Biochem company is pharmaceutical company

It can't afford power cut due to sensitive if of business is it required genrator for power bank up .

Company has two options that either it can purchase or take it on lease.we are evaluating both options

1) Purchase

Cost of new genrator =7000 OMR

Annual maintenance costs every year increasing by 10%

Year	Cost	Present value @ 10%
1	225	204.54
2	247.5	204.54
3	272.25	204.54
4	299.48	204.54
5	329.42	204.54
6	362.37	204.54
7	398.6	204.54
8	438.46	204.54
9	482.31	204.54

Total present value of maintenance cost =1636.32 OMR

Total cost involved =7000+1636.32

=8636.32 OMR

2) Leasing

Annual lease payment =1300 OMR

Present value of lease= annual payment * pv annuity factor @10% for 8 year

=1300*5.3349

=6935.37 OMR

So npv of cost under lease is less by 1701 Omr than purchase option .

So we should go for lease.

2) company wish to purchase genrator even it is not economical so company can consider factor -1)well coordination - if we managed generator so there will be well coordination in operation & maintenance of genrator. Hence maximum availability about to 100% but if we take it on lease so it could take time to maintenance and non availability of assets .

Further maintenance is included in lease payment so leasor use cheap part during maintenance to cut cost. And quensquently performance of genrator Affect. However this issue would not come of we purchase assets.