Question

SL BLUE , a construction company, is planning to acquire new earthmoving equipment at a cost of R150 million, and is considering how to finance the acquisition. The company can either lease or purchase the equipment.

The following information relates to these two options:

1. Purchase:

The company can purchase the equipment through a bank loan for the full cost of the equipment, repayable over five years in equal annual instalments incorporating interest at a rate of 11.39% per annum.

The equipment qualifies for a depreciation deduction of 40% of cost in the first year and 20% of cost in each year for the subsequent three years.

The useful life of the equipment is five years, at the end of which the equipment is expected to have a residual value equal to one third of its cost.

If the company purchases the equipment, it will spend R5 million per year on insurance and maintenance costs.

2. Lease:

The company can lease the equipment at an annual lease rental cost of R45 million, payable in advance over five years.

The tax deduction relating to the lease payments will occur at the end of each year.

Under the lease agreement, the lessor will be responsible for the insurance and maintenance of the equipment. The (CEO) has a friend visiting from overseas, who has advised that it would be preferable to lease the equipment rather than buy it.

The friend’s argument is that leasing would prevent SL BLUE own capital being tied up, since it would be the lessor who would buy and own the equipment.

SL BLUE is highly geared, and the friend has also suggested that leasing the equipment instead of borrowing to buy it would make SL BLUE balance sheet look better.

As an example of the convenience of leasing, the friend points to the rental car they have been using while visiting South Africa.

The corporate tax rate is 28%.

DO THE CALCULATIONS TO CHOOSE THE CORRECT OPTION AND EXPLAIN THE ADVANTAGES OF THE OPTION - PLEASE STEP BY STEP AS I NEED TO UNDERSTAND THIS BETTER

Answer 1

As in question , the friend sugggests leasing option. so we have to analyse the net advantage of choosing lease option. Computation as follows:

(AMOUNT-Rs. IN MILLION)

Particulars		Yr 0	Yr 1	Yr 2	Yr 3	Yr 4	Yr 5
Cost of Equipment		150	-	-	-	-	-
Depreciation (Note 1)	A	-	60	30	30	30	-
Rate of Tax	B	-	28%	28%	28%	28%	28%
Loss on Depreciation tax shield (NOTE 2)	C=(A*B)	-	(16.8)	(8.4)	(8.4)	(8.4)	-
Annual Lease Payment	D	-	(45)	(45)	(45)	(45)	(45)
Tax Sheild on lease payment	E=(D*B)	-	12.6	12.6	12.6	12.6	12.6
Gain on Insurance & Maintenance Cost (NOTE 3)	F	-	5	5	5	5	5
Loss on Salvage Value (NOTE 4)	G	-	-	-	-	-	(50)
Cashflow of Lease	H=(C+D+E+F+G)	-	(44.2)	(35.8)	(35.8)	(35.8)	77.4
Present Value Factor @ 11.39%	I		0.898	0.806	0.724	0.650	0.583
Present Value of Cashflow of Lease	(H*I)		(39.69)	(28.85)	(25.92)	(23.27)	(45.12)

AMOUNT OF BORROWING   150.00 MILLION

PRESENT VALUE OF LEASE 165.56 MILLION

DISADVANTAGE ON OPTING LEASE OPTION    15.56MILLION

WORKING NOTES:

1) DEPRECIATION

Ist Year:

Depreciation= 40% of cost = 150Million*40% =60Million

2nd Year to 4th Year :

Depreciation =20% of cost = 150Million*20% =30Million

2)IF WE ARE BORROWING WE CAN CLAIM DEPRECIATION AND TAX BENEFIT WILL BE AVAILABLE ON IT, WHICH WILL NOT BE AVAILABLE IN LEASING OPTION. IT IS AN INDIRECT DISADVANTAGE.

3)ON PURCHASING THE EQUIPMENT COMPANY HAS TO PAY INSURANCE AND MAINTENANCE COST FROM THEIR POCKET WHILE IN LEASING LESSOR IS RESPONSIBLE FOR SUCH PAYMENT. IT WILL BE A BENEFIT.

4)ON PURCHASING, COMPANY GET A SALVAGE VALUE OF ONE THIRD OF THE COST(I.E, 150MILLION*1/3=50MILLION) AS SALVAGE VALUE WHICH WILL NOT BE AVAILABLE IN LEASE.