The finance director of the Small Machine Par ts Ltd company is considering the acquisition of a lease of a small workshop in a warehouse complex that is being redeveloped by City Redevelopers Ltd at a steady rate over a number of years. City Redevelopers are granting such leases for five years on payment of a premium of £20,000.

The accountant has obtained estimates of the likely maintenance costs and disposal value of the lease during its five-year life. He has produced the following table and suggested to the finance director that the annual average cost should be used in the financial accounts to represent the depreciation charge in the profit and loss account.

The finance director, however, was considering whether to calculate the depreciation chargeable using the annuity method with interest at 15%.
Required:

(a) Calculate the entries that would appear in the profit and loss account of Small Machine Parts Ltd for each of the five years of the life of the lease for the amortisation charge, the interest element in the depreciation charge and the income from secondary assets using the ANNUITY METHOD. Calculate the net profit for each of the five years assuming that the operating cash flow is estimated to be £25,000 per year.

(b) Discuss briefly which of the two methods you would recommend.
The present value at 15% of £1 per annum for five years is £3.35214.
The present value at 15% of £1 received at the end of year 5 is £0.49717.
Ignore taxation.

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E 20,000 Years of life Purchase price Maintenance/repairs Year 2 Table prepared to calculate the annual average cost 2 3 5 20,000 20,000 20,000 20,000 1,000 1,000 1,000 1,000 3 1,500 1,500 1,500 4 1,850 1,850 5 2,000 20,000 21,000 22,500 24,350 26,350 Resale value 11,500 10,000 8,010 5,350 350 Net cost 8,500 11,000 14,490 19,000 26,000 Annual average cost 8,500 5,500 4,830 4,750 5,200