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. 3

Answer 1

Answert Option : Finance Lease year! year 2 year 3 Lease cost 300.000 300,000 300,000 84,000 84,000 84,000, Tan Benefit of Lease Cost 28% 216.000 216.000 Net Cost 216,000 1 0.4266123 0.8586104 Discount Rate 117. (1-28) 216,000 Discounted cash flow 200,148 185,460 Total net cost 601,608 Option i purrchase yearo yeorr! year 2 Year 3 Initial cost 600000 Maint 80,000 80.000 80.000 200 000 200,000 Depreciation 200,000 78,400 Tone benfit of Dep & Maint 78,400 78,400 G00000 1.600 1600 Net cush outflow 1600 1 Discount Rate 117.00-23) 0.42661231 0.85861036 0.79599893 Os comted cash flow 600000 1483 1374 1273 Total Net Cost 604,129 It's better to Lease the machine as the cost is low,