LEASE VS PURCHASE Shoreline Ltd is considering investing in a machine that will
ID: 2731101 • Letter: L
Question
LEASE VS PURCHASE
Shoreline Ltd is considering investing in a machine that will allow them to further automate their manufacturing processes. They could either lease or purchase this machine. The machine will require them to hold greater amounts of inventory and accounts receivable. The firm currently pays tax at the rate of 30% per annum. The firm uses it’s after tax cost of debt of 7% as the discount rate for this comparison.
Purchase option: The machine can be purchased for $600,000 and there will be installation costs of $29,500. The firm can finance the purchase of the new machine with a 10%, five year loan. The year end instalment payments for this loan would be $166,060.51. The machine would be fully depreciated using the straight line method over its five year effective life. If the machine is purchased, the firm will pay $16,800 per annum for a contract covering all maintenance costs.
Lease option: The firm’s supplier has indicated that it is prepared to lease the machine to the firm. The lease would require annual, beginning-of-the-year payments of $165,500 over the five year life of the lease. All maintenance costs will be borne by the lessor. At the termination of the lease, the lessee will exercise its option to purchase the machine for $8,200.
(a) Do the necessary calculations to enable you to recommend whether Shoreline Ltd should lease or purchase the new machine. Show all your calculations clearly in table form.
(b) Write a short report of between two hundred (200) and three hundred (300) words to the directors of Shoreline Ltd describing the non-financial factors that you think should be taken into consideration in addition to your financial analysis above.
(c) Based on your analysis in a) and b) above, recommend whether you think Shoreline Ltd should lease or buy the machine.
Explanation / Answer
a. I: NPV under Purchase option:
Repayment shedule
Depreciation per year = 629500/5 = $125900
Tax savings on dep = 125900 x 0.30 = $37770
Cumulative PVF@7% for 5 years = 4.100
PV of tax savings on dep = $154857
Tax savings on interest:
Maintenance cost net of tax = 16800 x (1-0.30) = $11760
PV of maintenance cost = 11760 x 4.100 = $48216
PV of instaments = 166060.51 x 4.100 = $680848.09
NPV of cost = PV of maintenance cost + PV of instalments - PV of tax savings on interest - PV of tax savings on dep.
= 48216 + 680848.09 - 51383.39 - 154857
= $522823.70
II: NPV under Lease option:
NPV of cost = (115850 x Cumulative PVF@7% for 0-4 years) + (8200 x PVF@7% for 5th year)
= (115850 x 4.387) + (8200 x 0.713)
= $514080.55
The NPV of cost under lease option is lower. Hence Shoreline Ltd should lease the machine.
Year O/s in beg. Instalment Interest @ 10% Principal O/s in end 1 629500 166060.51 62950 103110.51 526369.49 2 526369.49 166060.51 52638.95 113421.56 412947.93 3 412947.93 166060.51 41294.79 124765.72 288182.21 4 288182.21 166060.51 28818.22 137242.29 150939.92 5 150939.92 166060.51 15120.59 150939.92 -Related Questions
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