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

a) If the company wants to choose between purchasing the Asset or leasing the Asset then it will find out net present value of both the alternatives at year zero. The alternative with lower cost that is lower net present value will be chosen as it will prove to be more economical to the company in comparison to the other alternative.

NPV = Discounting factor * Cash flow

Discounting factor =(1/(1+i)n)

Cash flow = previous year cash flow + (previous year clash flow * 10%)

Where,

i = interest rate

n = number of year

In the given question i =10%

So,

NPV of purchasing asset :-

Year	Cash flow	Discounting factor	Present Worth
0	6000		6000
1	225	0.9090	204.52
2	247.5	0.4545	112.48
3	272.25	0.3030	82.49
4	299.475	0.2272	68.04
5	329.4	0.1818	59.88
6	362.36	0.1515	54.89
7	398.6	0.1298	51.73
8	438.46	0.1136	49.80
Total			6479.31

NPV of leasing:-

When the Cash flow is constant in all the years

NPV = Cash flow * Aggregate of all discounting factors for n years

NPV of leasing = 1300 * 2.4704 = 3211.52

Thus ,it is evident from the above analysis that leasing a generator is a more economical option for the company.

b) When a company is purchasing an equipment it considers the following factors in order to justify their decision:-

1) Benefits to Cost Ratio :-

Benefits to cost ratio is the ratio of present value of cash inflows divided by present value of cash outflows point hire benefits to cost ratio portrays that the asset is economical to purchase

2) Payback period :-

It helps to understand how much amount of time will be required in order to recover the cost that is invested in the project.

3) Net Present Value :-

It considers at discounted value of cash inflows and cash outflows. The project is economically viable if the present value of cash inflow is greater than the present value of cash outflow which means npv is greater than zero.

4) Internal Rate of return:-

Internal rate of return as the interest rate at which the net present worth becomes zero. The general rule for accepting a project is that internal rate of return should be greater than MARR.

5) Opportunity Cost :-

Opportunity cost is a cost associated with giving of one alternative in order to choose the other alternative. The project which has a lower opportunity cost must be chosen over a project which has a higher opportunity cost when compared.