Question

QUESTION 2 Part A ZAZ Sdn Bhd is considering how to finance the acquisition of a machine costing RM750,000 with an operating life of five years. There are two financing options. The machine could be leased for an annual lease payment of RM155,000, payable at the start of each year. Alternatively, the machine could be bought for RM750,000 using a bank loan charging interest at an annual rate of 7% per year. At the end of five years, the machine would have a scrap value of 10% of the purchase price. If the machine is bought, maintenance costs of RM20,000 per year would be incurred. Taxation must be ignored. Required: a. Evaluate whether ZAZ Sdn Bhd should use leasing or borrowing as a source of finance, explaining the evaluation method which you use. (10 marks) b. Discuss the two advantages of leasing as a source of both short-term and long-term finance. (4 marks)

Answer 1

a]

Net advantage of leasing is the NPV of the lease relative to the purchase.

This is calculated by calculating the present value of the advantage each year.

Advantage each year = Cash flow with leasing - cash flow with buying.

Buying :

Cash outflow in year 0 = cost of equipment.

Cash outflow in years 1 to 4 = maintenance cost

Cash inflow in year 5 = salvage value - maintenance cost

Leasing :

Cash outflow each year = lease payment

NPV of leasing vs buying

Advantage each year = Cash flow with leasing - cash flow with buying.

Present value factor (discount factor) each year = 1 / (1 + discount rate)^year.

Discount rate = cost of borrowing = 7%.

Net Advantage of leasing each year = advantage amount * discount factor.

NPV of the lease relative to the purchase (NAL) = RM 98,512.24

As the NAL is positive, the machine should be leased

A B с D E F - 1 Year 2 3 0 4 1 5 6 7 4 5 9 Buying Purchase Maintenance Salvage (750,000) (20,000) (20,000) (20,000) (20,000) (20,000) 75,000 Н. Discount Factor @ Leasing Advantage 7% NAL Total (750,000) (155,000) 595,000 1.0000 595,000 (20,000) (155,000) (135,000) 0.9346 (126,168) (20,000) (155,000) (135,000) 0.8734 (117,914) (20,000) (155,000) (135,000) 0.8163 (110,200) (20,000) (155,000) (135,000) 0.7629 (102,991) 55,000 (55,000) 0.7130 (39,214) TOTAL 98,512.24 2 3 8

А В с D E F G H 1 Year Leasing Advantage Discount Factor @ 7% NAL N =B3 Buying Purchase Maintenance Salvage Total -750000 -20000 =C4 -20000 =C5 -20000 =C6 -20000 =C7 -20000 75000 =C8+D8 30 4 1 5 2 6 3 7 4 8 5 9 .. -155000 =F3-E3 -155000 =F4-E4 -155000 =F5-E5 - 155000 =F6-E6 -155000 =F7-E7 =F8-E8 =1/1.071A3 =1/1.071A4 =1/1.071A5 =1/1.074A6 =1/1.071A7 =1/1.07^A8 TOTAL =G3*H3 =G4*H4 =G5*H5 =G6*H6 =G7*H7 =G8*H8 =SUM(13:18)

b]

Two advantages of leasing are :

• The burden of maintenance and repairs remain with the lessor. Thus, only the lease payments need to be paid, and nothing more. This results in certainty of cash flows. If the machine was owned, the burden of maintenance and repairs lies with the lessee, and thus there is uncertainty regarding the actual cash flows
• Leasing involves lower upfront costs, unlike buying where the upfront cost needs to be paid. The future cash outflows of leasing are tax-deductible whereas in loan payments only the interest component is tax-deductible