A company is considering whether to buy a new machine at a cost of $100,000 or alternatively to lease it for $35,000 p.a. (lease payments payable at the start of each year). Buying it will involve borrowing money at an after tax interest cost of 7% p.a.

A company is considering whether to buy a new machine at a cost of $100,000 or alternatively to lease it for $35,000 p.a. (lease payments payable at the start of each year). Buying it will involve borrowing money at an after tax interest cost of 7% p.a. If the machine is bought, it will be bought on the last day of the current financial year. The machine will be needed for 4 years, and (if purchased) will have a scrap value $10,000 after 4 years. Corporation Tax is 30% (payable one year after the end of the financial year). Capital Allowances are 25% (reducing balance). Should the machine be leased or purchased?

Expert Solution

Evaluation of Lease Option
Year	Lease rent	Tax Shield	Net	PVF @ 7%	PV
0	-35000		-35000	1	-35000
1	-35000	10500	-24500	0.934579439	-22897.1963
2	-35000	10500	-24500	0.873438728	-21399.2488
3	-35000	10500	-24500	0.816297877	-19999.298
4	0	10500	10500	0.716050769	7518.533077

				Total	-91777.21

Evaluation of Loan Option
Year	Instalment	Tax Shield Depreciation	Tax shield Interest	Net	PVF @ 7%	PV
1	-31547.08	7500	3000	-21047.08	0.9346	-19670.1682
2	-31547.08	5625	2353.588	-23568.492	0.8734	-20585.634
3	-31547.08	4218.75	1642.534	-25685.796	0.8163	-20967.2608
4	-31547.08	3164.063	860.375	-27522.643	0.7629	-20996.8922
4	Salvage (Net of tax)			16492.190	0.7629	12581.81279

					Total	-69638.1425

Loan option is better as it has lower cost in comparision to lease option.

Working note : Loan amortisation schedule

Year	Opening Balance	Instalment	Principal Repay	Interest	Closing Balance
1	100000	31547.08	21547.08	10000	78452.92
2	78452.92	31547.08	23701.788	7845.292	54751.132
3	54751.132	31547.08	26071.967	5475.1132	28679.165
4	28679.1652	31547.08	28679.163	2867.91652	0.002

Working note: Depreciation

Year	Opening Balance	Depreciation	Closing balance
1	100000	25000	75000
2	75000	18750	56250
3	56250	14062.5	42187.5
4	42187.5	10546.875	31640.625

Working Note:

Salvage net of tax = Salvage + Tax benefit on capital loss

= 10000 + (Book value - Salvage) * Tax rate

= 10000 + (31640.625 - 10000)*0.30 = $16492.19

Working Note:

Calculation of before tax cost of loan = After tax cost / (1-t)

= 7 / (1 - 0.30)

= 10%

Calculation of instalment = Loan / PVAF (10% , 4)

= 100000 / 3.1699

= $31547.08

Salvage net of tax = $16492.19

Calculation of before tax cost of loan = 10%

Calculation of instalment = $31547.08

Junaid answered 2 years ago

A company is considering whether to buy a new machine at a cost of $100,000 or alternatively to lease it for $35,000 p.a. (lease payments payable at the start of each year). Buying it will involve borrowing money at an after tax interest cost of 7% p.a.

A company is considering whether to buy a new machine at a cost of $100,000 or alternatively to lease it for $35,000 p.a. (lease payments payable at the start of each year). Buying it will involve borrowing money at an after tax interest cost of 7% p.a. If the machine is bought, it will be bought on the last day of the current financial year. The machine will be needed for 4 years, and (if purchased) will have a scrap...

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A new machine will cost $100,000 today and generate cash inflows of $35,000 each year for 4 years. (a) If the firm has a 10% cost of capital, should the firm buy this machine under NPV rule? (Please calculate the NPV of this investment and explain your reason) (b) How high can the discount rate be before you would reject buying this machine? (Please explain the reason. Your answer should have at least one decimal digit)

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A company is considering whether to buy a new machine at a cost of $100,000 or alternatively to lease it for $35,000 p.a. (lease payments payable at the start of each year). Buying it will involve borrowing money at an after tax interest cost of 7% p.a.

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