Permafrost plc needs a new computer network but is uncertain whether to buy the system or to lease it from Slush plc. The system will cost £800 000 if bought and Permafrost plc would borrow to finance this. Information on the two options is as follows.

Option 1 If the system is leased, Slush plc will expect an annual lease payment of £150 000, payable in advance. Slush plc will be responsible for servicing the system, at no additional cost, over the eight-year life of the system.

Option 2 If the system is bought, Permafrost plc will be responsible for servicing the system at an annual cost of £10 000. It has a choice of three financing methods:

1 It could issue 12 per cent bonds, to be redeemed in eight years’ time at par. The bonds will be secured on existing fixed assets.

2 It could raise an eight-year floating rate bank loan. This loan would be repaid in equal instalments over its life and secured on existing land and buildings.

3 It could issue zero coupon bonds, to be redeemed at par in eight years.

Permafrost plc pays tax one year in arrears at an annual rate of 30 per cent and can claim capital allowances on a 25 per cent reducing balance basis. The current before-tax cost of debt of the company is 10 per cent and this is not expected to change as a result of the financing choice made in connection with the new computer network.

(a) Determine the expected market values of the 12 per cent bond issue and the zero coupon bond issue, and critically discuss the relative merits of the three debt finance methods to Permafrost plc.

(b) Evaluate whether Permafrost plc should lease or buy the new computer network.