Question

Question 1.2 (12 Marks)
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 3% 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 R 300 000 per year, paid at the start of each year for three years.
The machine costs R 600 000 and it is expected that it will require maintenance of R 80 000 per year, if bought. It is also expected that the machine can be sold for R 100 000 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 11%.
Required:
Determine the net advantage of leasing and advise the company on the option they should take based on your findings.

Answer 1

NET ADVANTAGE OF LEASING WHEN WE COMPARE TO PURCHASE OF A NEW MACHINE IS.

WHEN PURCHASE A NEW MACHINE ITS COST AND OTHER EXPENSES INCLUDING TAX , MAINTENANCE, DEPRECIATION ETC GOES BEYOND THE AMOUNT OF 11,00,000/- EVENTHOUGH CALCULATE WITH THE AMOUNT OF NETSALE AMOUNT OF MANCHINE IF PURCHASED AND DISPOSED.

IN CASE OF PURCHASE:

MACHINE COST- 6,00,000/-

MAINTENANCE PER YEAR-2,40,000(80,000*3 YEAR)

TAX AMOUNT-1,68,000/-(28%)

BEFORE TAX COST-66,000(11%)

DEPRECIATION-1,80,000(ASSUME 10% STREIGHT LINE METHOD FOR 3 YEAR)

TOTAL WILL COME APPROXIMATELY RS. 12,54,000/-.

THE SALE AMOUNT WE WILL GET ONLY 1,00,000/-

BUT IN CASE OF LEASE THE TOTAL AMOUNT WILL COME ONLY RS. 9,00,000/-.

COMPARITIVELY NO RISK AND NO MAINTENANCE COST AND GUARENTE FROM THE LESSOR.

LEASING IS THE BEST WAY TO CHOOSE RATHER THAN PURCHASING A MACHINE.