Question

Har Ltd. is a logistics company operating in Subang Jaya. They have recently bid for a Selangor wide contract of providing medicines to all the health units. This is an excellent opportunity for the company to expand their business.

To fulfill this requirement, Omair, who is the CEO of the company is analyzing, how he should expand his fleet. The basic question in front of him is whether he should buy his own fleet of trucks, or lease them. And also the question, whether he should buy them by raising capital through bonds or equities.

He needs 100 trucks to fulfill the requirements. He has just finished a call with ORIX Leasing Ltd, who have said, that they would be willing to lease them 100 trucks for MYR 450,000 for 5 years.

Instead, if Omair decides to buy the vehicles he is estimating that he would be spending MYR 18000 per truck. And the question is how to finance. He was checking the debt market rates, and found out that for similar risk companies, the bonds with a face value of 1000 were trading at MYR 940 with 5 years to maturity (annual coupon payment of 5%).

Buying the trucks also means that he would be incurring a cost of MYR 85,000 each year for the whole fleet. The company’s tax rate is 30%. The tax laws allow straight-line depreciation for 5 years. The cost of capital is the same as the cost of debt.

Questions

1. What do you think whether Omair should BUY the trucks or LEASE them? Why?

2. Would it be wiser for him to raise equity instead of bonds IF he goes for Buy option?

Answer 1

Cost of debt (Kd )= (Interest ( 1-tax)+ discount/ no of year)/ value of bond received*100

=( (50*.70)+(60/5))/ 940*100=5%

As cost of equity equals to cost of debt, weighted average cost of capital is 5%

As cost of equity & debt is same , so from the point of view of return both option are indifferent. So for deciding whether to go for equity or debt , Firm should check its current debt to equity ratio & likelyhood of cash inflows for debt repayment.

In case firm had huge debt or firm don't have stable cash inflows then firm should go for equity as default in repayment of debt may lead to bank corrupsy.