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Homework answers / question archive / Socks Ltd manufactures socks and legwarmers and wants to expand its product line
Socks Ltd manufactures socks and legwarmers and wants to expand its product line. The management of the company has indicated that a new machine is required to manufacture a new line of brightly coloured socks. To purchase the machine, it has negotiated financing with a favourable before tax cost of 9% interest per annum with equal annual instalments. Alternatively, the company can enter into a direct financial lease with the manufacturer of the machine, which means that the manufacturer will offer the machine and maintenance on it for the useful life of the machine at a cost of R190 000 per year, paid at the start of each year for three years. The machine costs R400 000 and it is expected that it will require maintenance of R70 000 per year, if bought. It is also expected that the machine can be sold for R50 000 at the end of its useful life of three years. The machine can be depreciated by way of the straight-line method over a period of three years. A tax rate of 28% is applicable. The company has a before tax cost of debt of 10%.
Required: Determine the net advantage of leasing and indicate whether the company should lease or purchase in the given space.
Answer:
| Leasing | Year 0 | Year 1 | Year 2 | Year 3 |
| Pay-out | (190,000.00) | (190,000.00) | (190,000.00) | - |
| Net Cash outflow (NPV at 10%) | (519,752.07) | |||
| Buying | Year 0 | Year 1 | Year 2 | Year 3 |
| Cost of Equipment | 400000 | |||
| EMI (a) at 9% | (152,638.72) | (152,638.72) | (152,638.72) | |
| Principal component | 121,572.40 | 132,976.73 | 145,450.87 | |
| Interest component | 31,066.31 | 19,661.99 | 7,187.85 | |
| Maintenance (b) | (70,000.00) | (70,000.00) | (70,000.00) | |
| Terminal Value (c) | 50000 | |||
| Depreciation (d) | 116666.6667 | 116666.6667 | 116666.6667 | |
| Cashflow outflow (a+b+c+d*28%) | (189,972.05) | (189,972.05) | (139,972.05) | |
| Net Cash outflow (NPV at 10%) | (434,866.63) | |||
| *Year 0 indicates payments made on day 1 | ||||
| * Leasing gives and advantage of flexible cancellation thus avoiding further expenditure if the product fails | ||||
| * Considering the net cash outflow, Buying the equipment is profitable than leasing due to less cash outflow | ||||
| * This is due to tax benefit on depreciation and lower interest rate | ||||
