Question

1. Abbas ltd. is a manufacturing company involved in manufacturing plastic products. It has received orders from a foreign company to manufacture plastic bags and disposable cups and which the company considers it as a positive sign for growth in the future. The company’s existing machinery will not be sufficient enough to produce for the present demand and to meet the foreign order. Two options are available (1) to lease a machinery or (2) buy a new machinery using bank loan.

If the company takes the machinery for lease it has pay a lease rent of OMR 110,000. All the expenses for the maintenance of the machinery will be borne by the Abbas ltd. If they decide to buy the machinery they have to borrow the required money from the bank at the rate of 7 % p.a to purchase the machinery. The cost of the machinery is OMR 485,000 which has a residual value of OMR 10,000. The money borrowed will be paid in equal instalments in 5 years inclusive of principal and interest at the end of each year. The principal amount to be paid each year would be OMR 97,000. The machinery would be depreciated on a Written down value method (with residual value). The Present value is taken at 8%

1. If the company decides to take the machinery on lease. Advise the company whether it is better to pay the lease rent a) In the beginning of each year or b) at the end of the year with suitable calculations.
2. Advise them on buying the machinery or leasing the machinery with suitable calculations and Justify your answer.

Answer 1

1. Calculation of Present Value (PV) of Lease Option :

a) When payment is made at the beginning of the period :

b) When payment is made at the end of the period :

2. Calculation of loan from Bank option :

Conclusion :

1.When Loan option is compared with Lease paid at the beginning of the period; Loan option will be preferred as the PV of Loan is cheaper than Lease Option.

2. When Loan option is compared with Lease paid at the end of the period; Lease option will be preferref as the PV of Lease is cheaper than Loan Option.

NOTE:

In the absence of information about tax. No tax shield has been considered on Lease Payment, Interest and Depreciation. Tax shield on these payments may result into other conclusion.