Question
In: Finance
QUESTION ONE Nyla Boilers is considering the acquisition of a new CNT machine for their operations....
QUESTION ONE
Nyla Boilers is considering the acquisition of a new CNT machine
for their operations. The
machine may be purchased outright or leased.
The Purchase Option
| Cash purchase | R600 000 |
| Annual software | R10 000 |
| Maintenance Costs | |
| Year 1 and Year 2 | R5000 per year |
| Year 3 | R 9000 |
| Year 4 | R20 000 |
The machine will be sold after 4 year for 15% of its cash purchase price.
The Leasing Option
An initial deposit of R80 000 is required and the lease will run
for 4 years. Annual payments of
R120 000 need to be made at the end of each of the four years. On
expiry of the 4th year the
deposit will be refunded. No other costs will be borne by Nyla
Boilers.
The rate of return is 7%
Tax rate: 30%
Required:
1.1 Determine the present value of cash flows associated with each
alternative. (22)
1.2 Which option will you recommend to Nyla Boilers. (3)
Solutions
Expert Solution
(1.1) Let's evaluate both options:
Assumption:
Purchase Option: Book value of machine after 4 years is more than the resale value (15%), so no tax liability arises.
Lease Option: Machine is not bought by Lessee after lease period, so tax liability doesn't rise in this case as well.
(1.) Purchase Option:
| CF0 | CF1 | CF2 | CF3 | CF4 | |
| Initial Cost | -600000 | - | - | - | - |
| Annual Software | - | -10000 | -10000 | -10000 | -10000 |
| Maintenance | -5000 | -5000 | -9000 | -20000 | |
| Resale Value (15% of Cash Value) | - | - | - | +90000 | |
| Total Cash Flow | -600000 | -15000 | -15000 | -19000 | +60000 |
| PV of Cash Flow (Discount rate of 7%) | -600000 | -14019 | -13102 | -15510 | 53309 |
| PV of total cost | -589322 |
(2.) Lease Option:
| CF0 | CF1 | CF2 | CF3 | CF4 | |
| Deposit | -80000 | - | - | - | - |
| Annual Lease Payment | - | -120000 | -120000 | -120000 | -120000 |
| Refund of Deposit | - | - | - | - | +80000 |
| Total Cash Flow | -80000 | -120000 | -120000 | -120000 | -40000 |
| PV of CF | -80000 | -112150 | -104813 | -97956 | -35540 |
| PV of total cost | -430457 |
(1.2)
Since lease option costs less as compared to Purchase option, I'll recommend for the lease option.
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