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Ayan ranch Inc
Ayan ranch Inc. wants to acquire a mechanized feed spreader that costs $80,000. The ranch
company intends to operate the equipment for 5 years, at which time it will need to be replaced.
However, it is expected to have a salvage value of $10,000 at the end of the fifth year. The asset
will be depreciated on a straight-line basis ($16,000 per year) and Ayan is in 30 percent tax bracket.
Two means of financing the feed spreader are available. A lease arrangement calls for lease
payments of $19,000 annually, payable in advance. A debt alternative carries a interest cost of 17
percent. Debt payments will be at the start of each of the 5 years using the mortgage type of debt
amortization.
a) Compute present value cash outflows under each financing alternative and advise.
b) Discuss disclosure difference of leases as per IFRS 16 from its predecessor IAS 17.
Expert Solution
Ans:
(a)
Alternative 1- Borrow and buy
Cost of machine/Asset - $80000 , Borrowing rate - 17%
Annual payment = Cost of machine /(1 + PVAF(17%,0-4 years))
Annual payment = $80000/3.743
Annual payment = $21373
Calculation of interest:
| Year | Opening Principal | Total payment | Interest | Principal component | Principal outstanding |
| 0 | $80000 | $21373 | 0 | $21373 | $58627 |
| 1 | $58627 | $21373 | $9967 | $11406 | $47221 |
| 2 | $47221 | $21373 | $8028 | $13345 | $33876 |
| 3 | $33876 | $21373 | $5759 | $15614 | $18262 |
| 4 | $18262 | $21373 | $3111 ($18262-$21373) | $18262 | 0 |
| Total | $80000 |
Depreciation p.a - $16000....(given)
Calculation of tax saving on depreciation and interest:
| Year | Interest | Depreciation | Total | Tax saving @ 30% |
| 1 | $9967 | $16000 | $25967 | $7790 |
| 2 | $8028 | $16000 | $24028 | $7208 |
| 3 | $5759 | $16000 | $21759 | $6528 |
| 4 | $3111 | $16000 | $19111 | $5733 |
| 5 | $16000 | $16000 | $4800 |
Present Value of Outflow:
| Year | Instalment | Tax saving | Net outflow | PV @ 11.9% (after tax) i.e 17%( 1- 0.30) | Present Value |
| 0 | $21373 | 0 | $21373 ($21373-0) | 1 | $21373 |
| 1 | $21373 | $7790 | $13583 | 0.894 | $12143 |
| 2 | $21373 | $7208 | $14165 | 0.799 | $11318 |
| 3 | $21373 | $6528 | $14845 | 0.714 | $10599 |
| 4 | $21373 | $5733 | $15640 | 0.638 | $9978 |
| 5 | $4800 | ($4800) | 0.570 | ($2736) | |
| $62675 | |||||
| Salvage Value | ($10000) | 0.570 | ($5700) | ||
| P.V of Outflow | $56975 |
Alternative 2 - Leasing Option
Lease rental - $19000 payable in advance
| End of year | Lease payment | Tax Sheild @ 30% | Cash outflow | PVIFA @ 11.9% (after tax) | Present Value |
| 0 | $19000 | 0 | $19000 | 1 | $19000 |
| 1-4 | $19000 | $5700 | $13300 | 3.044 | $40485 |
| 5 | 0 | ($5700) | ($5700) | 0.570 | ($3249) |
| Total PV of outflow | $56236 |
Decision - Present Value of cash outflow is lesser in leasing option than borrow and hence leasing is recommended.
(b) disclosure difference of leases as per IFRS 16 from its predecessor IAS 17:
| IAS-17 | IFRS-16 |
| Disclosure in balance sheet requires separate disclosure of finance lease and operating lease | IFRS is silent as to distinction between finance and operating lease. |
| For finance lease, disclosure shows the nature of arrangement of finance for the acquisition of underlying asset | Disclosure in balance sheet requires "right of use" assets |
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