Question

Socks Ltd manufactures socks and legwarmers and wants to expand its product line. The management of the company has indicated that a new machine is required to manufacture a new line of brightly coloured socks. To purchase the machine, it has negotiated financing with a favourable before tax cost of 3% interest per annum with equal annual instalments. Alternatively, the company can enter into a direct financial 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 of R 300 000 per year, paid at the start of each year for three years. The machine costs R 600 000 and it is expected that it will require maintenance of R 80 000 per year, if bought. It is also expected that the machine can be sold for R 100 000 at the end of its useful life of three years. The machine can be depreciated by way of the straight-line method over a period of three years. A tax rate of 28% is applicable. The company has a before tax cost of debt of 11%. Required: Determine the net advantage of leasing and advise the company on the option they should take based on your finding

Answer 1

Questions ask you to evaluate the Two options whether purchase of machine is better or to take it on lease is better purely in terms of financials.

You need to calculate the Costs associated with both options  and analyse which is less costly.

Given rate 11% is before tax. We need after tax rate as the cash flows we use also after tax. So 11(1- tax)

=11( 1- 0.28) = 7.92%

Step 1: Evalute Lease option:

300000 per year lease payments for 3 years starting at the beginning of year. Present value of Net Cost in this option is:

Year end	Cash outflow before tax	Tax saving on Lease payments	Net Cash outflows	PV factor @ 7.92%	Present Value
0	300000	84000	216000	1	216000.00
1	300000	84000	216000	0.9266	200148.26
2	300000	84000	216000	0.8584	185408.30
				Total	601556.56

Total Costing in Lease is 601556.56

Step-2 Evaluation Buying Options;

1st you need to calculate the Anunual payments and interest part.

EMI = 212118 Approx

Now draw amortization table to calculate the Interest portion a separetely:

Beginning Balance	Interest @ 3%	EMI	Principal Portion ( EMI - Interest)	Ending Balance ( Beginning value - Principal)
600000.00	18000.00	212118.00	194118.00	405882.00
405882.00	12176.46	212118.00	199941.54	205940.46
205940.46	6177.54	212118.00	205940.46	0.00

Present value of all costing is as:

Year end	EMI/Annual Payments	Tax saving on interest payments	Tax saving on Depreciation of 200000	After tax Maintenance cost= 80000x0.72	Salvage value Less tax on captal gain. 100000-(100000*0.28)	Net Cash outflows Annual payment + Maintenance cost - Savings	PV factor @ 7.92%	Present Value
1	212118	5040.00	56000	57600	0	208678.00	0.9266	193363.60
2	212118	3409.41	56000	57600	0	210308.59	0.8584	180522.95
3	212118	1729.71	56000	57600	0	211988.29	0.7952	168563.93
3	0	0	0	0	72000	-72000	0.7952	-57254.40
							Total	485196.08

= 485196.08

Net advantage on lease = 485196.08-601556.56 = -116360.48

So it is clear from th above working that took loan and purchase machnery is better option than lease.