Question 2 Standard Tyres & Services (STS) is negotiating a lease on new equipme
ID: 2807694 • Letter: Q
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Question 2 Standard Tyres & Services (STS) is negotiating a lease on new equipment that would cost RM85,000.00 if purchased. The equipment, with its useful life of 4 years, will be depreciated using the straight line method towards a RM5,000.00 salvage value. The new equipment would be used for 4 years and then sold, because the firm plans to move to a new premise at that time. A maintenance contract on the equipment would cost RM3,000.00 per year, payable at the end of each year. To purchase the equipment, STS could obtain a 4-year loan at a before-tax cost of 10% p.a., with interest calculated on a yearly reducing balance. Annual instalments are to be paid at the end of the year. Alternatively, STS could lease the equipment for 4 years for a lease payment of RM30,000.00 per year, payable at the beginning of each year. The lease payment is inclusive of maintenance. The firm is in the 40% tax bracket. If there is a positive Net Advantage to Leasing, STS will lease the equipment. Otherwise, it will buy it. What is the NAL?Explanation / Answer
NPV OF BUYING: 1 2 3 4 Repayment of principal of loan (85000/4) -21250 -21250 -21250 -21250 After tax Interest [see workings below} -5100 -3825 -2550 -1275 After tax maintenance cost (3000*60%) -1800 -1800 -1800 -1800 Tax shield on depreciation [(85000-5000)/4]*40% 8000 8500 8500 8500 After tax residual value 5000 After tax net cash flows -20150 -18375 -17100 -10825 PVIF at 6% (10*(1-t)] 0.94340 0.89000 0.83962 0.79209 PV at 6% -19009 -16354 -14357 -8574 NPV of Buying -58295 NPV OF LEASING: After tax lease rent = 30000*0.60 = -18000 PV of after tax lease rent (Annuity due) = 18000*1.06*(1.06^4-1)/(0.06*1.06^4) = -66114 NAL = -66114-(-58295)= -7819 As the NAL is negative, the equipment should be purchased. WORKINGS FOR INTEREST ON LOAN: Beginning balance 85000 63750 42500 21250 Interest at 10% 8500 6375 4250 2125 After tax interest (60%) 5100 3825 2550 1275
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