Question

Question 9

The Director of Edinam Ltd are considering whether to replace the company’s equipment which cost GHS20,000 14 years ago. The equipment is used for the manufacture of tyres. The equipment’s remaining useful life is estimated to be 6 years and the net receipt from manufacturing tyres can be assumed to continue at GHS12,000 per year for that period. The net receipt comprises sales minus cost of production but no deduction has been made for depreciation or tax.

A leasing company has approached Edinam Ltd with an offer of new equipment. The equipment would be leased to Edinam Ltd for GHS9,000 per year payable at the beginning of each year in which the equipment is leased. The leasing contract would be effective for 6 years. The director of Edinam Ltd estimate that the equipment would produce GHC21,000 per year in net receipt (defined as above but before lease payment).

The manager of Edinam’s tyre making department has discovered that new equipment identical to that offered to the leasing company can be purchased for GHS40,000. The purchase equipment would have a useful life of 6 years. Annual net receipt would be the same as if the equipment were leased, except that, GHS1,000 per year would have to be sent on maintenance which in the leasing arrangement would be covered by the actual leasing charge.

If either leasing or purchase were undertaken the old equipment would be sold for GHS2,000. No tax would be payable on the receipt.

The following additional information is available

1. In any sale or purchase of equipment the appropriate payment would be received or made immediately and annual amount would occur at the end of the appropriate years except where specifically stated to the contrary.
2. Working capital is provided by creditors and can therefore be ignored in the option open to the company.
3. Edinam Ltd will be subject to 25% corporation tax and will be pay tax on taxable profit one year after those profits are earned. Taxable profits will be the company’s net receipt after deduction of leasing charges or maintenance cost where appropriate. If the new equipment is purchased the company will get a 100% capital allowance on the purchase price to set against taxable profit. The company’s profit from other source would be sufficient to ensure that relief is acquired (i.e. the tax relief can be treated as a receipt at the end of the second year).
4. Edinam’s cost of capital after tax in all relevant years is 12%

Required

Assess the worthwhileness of each of the options available to Edinam Ltd

Answer 1

Option I: Continue with the Old Equipment

	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7
Net Receipts (Sales minus Cost of Production)	12,000	12,000	12,000	12,000	12,000	12,000	-
Less: Depreciation (Straight Line Method)	(1,428.57)	(1,428.57)	(1,428.57)	(1,428.57)	(1,428.57)	(1,428.57)	-
Net Profit before Tax	10,571.43	10,571.43	10,571.43	10,571.43	10,571.43	10,571.43	-
Less: Tax at 25%	(2,642.86)	(2,642.86)	(2,642.86)	(2,642.86)	(2,642.86)	(2,642.86)	-
Net Profit after Tax	7,928.57	7,928.57	7,928.57	7,928.57	7,928.57	7,928.57	-
Add: Depreciation (Non-Cash Expense)	1428.57	1428.57	1428.57	1428.57	1428.57	1428.57	-
Add: Tax (To be Paid in Next Year)	2,642.86	2,642.86	2,642.86	2,642.86	2,642.86	2,642.86	-
Less: Payment of Prior Year Tax	-	(2,642.86)	(2,642.86)	(2,642.86)	(2,642.86)	(2,642.86)	(2,642.86)
Net Cash Inflow/(Outflow)	12,000.00	9,357.14	9,357.14	9,357.14	9,357.14	9,357.14	(2,642.86)
Present Value Factor at 12%	0.8929	0.7972	0.7118	0.6355	0.5674	0.5066	0.4523
Present Value of Cash Flows	10,714.29	7,459.46	6,660.23	5,946.63	5,309.49	4,740.62	(1,195.49)
Total Present Value (Year 1-7)	39,635.23

Option II: Leasing a New Equipment and Selling the Old Equipment

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7
Net Receipts (Sales minus Cost of Production)	-	21,000	21,000	21,000	21,000	21,000	21,000	-
Less: Lease Payment (On Due Basis)	(9,000)	(9,000)	(9,000)	(9,000)	(9,000)	(9,000)	-	-
Net Profit before Tax		12,000	12,000	12,000	12,000	12,000	21,000	-
Less: Tax at 25%		(3,000)	(3,000)	(3,000)	(3,000)	(3,000)	(5,250)	-
Net Profit after Tax		15,000	15,000	15,000	15,000	15,000	26,250	-
Add: Tax (To be Paid in Next Year)		3,000	3,000	3,000	3,000	3,000	5,250	-
Add: Receipt from Sale of Old machine	2,000	-	-	-	-	-	-	-
Less: Payment of Prior Year Tax		-	(3,000)	(3,000)	(3,000)	(3,000)	(3,000)	(5,250)
Net Cash Inflow/(Outflow)	(7,000)	18,000	15,000	15,000	15,000	15,000	28,500	(5,250)
Present Value Factor at 12%	1	0.8929	0.7972	0.7118	0.6355	0.5674	0.5066	0.4523
Present Value of Cash Flows	(7,000)	16,071.43	11,957.91	10,676.70	9,532.77	8,511.40	14,438.99	(2,374.83)
Total Present Value (Year 1-7)	61,814.37

Option II: Purchasing a New Equipment and Selling the Old Equipment

	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7
	GHS	GHS	GHS	GHS	GHS	GHS	GHS
Net Receipts (Sales minus Cost of Production)	21,000	21,000	21,000	21,000	21,000	21,000	-
Less: Depreciation (Straight Line Method)	(6,666.67)	(6,666.67)	(6,666.67)	(6,666.67)	(6,666.67)	(6,666.67)	-
Less: Maintenance Costs	(1,000)	(1,000)	(1,000)	(1,000)	(1,000)	(1,000)
Net Profit before Tax	13,333.33	13,333.33	13,333.33	13,333.33	13,333.33	13,333.33	-
Less: Tax at 25%	-	(3,333.33)	(3,333.33)	(3,333.33)	(3,333.33)	(3,333.33)	-
Net Profit after Tax	13,333.33	10,000.00	10,000.00	10,000.00	10,000.00	10,000.00	-
Add: Depreciation (Non-Cash Expense)	6666.67	6666.67	6666.67	6666.67	6666.67	6666.67	-
Add: Tax (To be Paid in Next Year)	-	3,333.33	3,333.33	3,333.33	3,333.33	3,333.33	-
Add: Receipt from Sale of Old machine	2,000	-	-	-	-	-	-
Less: Payment of Prior Year Tax	-	-	(3,333.33)	(3,333.33)	(3,333.33)	(3,333.33)	(3,333.33)
Net Cash Inflow/(Outflow)	22,000.00	20,000.00	16,666.67	16,666.67	16,666.67	16,666.67	(3,333.33)
Present Value Factor at 12%	0.8929	0.7972	0.7118	0.6355	0.5674	0.5066	0.4523
Present Value of Cash Flows	19,642.86	15,943.88	11,863.00	10,591.97	9,457.11	8,443.85	(1,507.83)
Total Present Value (Year 1-7)	74,434.84

Note: Since 100% Capital Allowance is available for Purchase Price of Equipment and the question states that sufficient profit will be avaialble to acquire relief. Therefore, there is Nil Tax in Year 1 and no Payment is made in Year 2.

SUMMARY:

Option	Net Present Value
Option I	39,635.23
Option II	61,814.37
Option III	74,434.84

Therefore, it can be concluded that in Option III the Net Present Value of Future Cashflows is higher as compared to other option. Therefore, management should buy New Equipment.