CB Ltd needs funds to finance the purchase of a new piece of production machinery for a six year period. The possibility of leasing the asset under an operating lease, rather than buying the asset, is also under consideration.

The machine would cost 1,500,000 to purchase today and has a working life of six years. At the end of this period the resale value of the machine is expected to be zero. If purchases, the machine would cost 50,000 to maintain for its first year of operation and this amount would increase at 4 per cent each year for the expected life of the asset.

Leasing the machine would involve an initial payment of 300,000 immediately and five additional annual payments of the same amount on the first day of the calendar and tax year over the life of the machinery.

The company's chairman thinks the leasing proposal is very attractive as the annual lease payment is below the estimated net cash flow from the investment of 450,000 per annum.

The equipment qualifies for 20 per cent reducing balance tax depreciation allowances per annum and the corporate tax rate is 30 per cent, with tax paid one year in arrears of the tax year end.

Given its credit risk CB Ltd is able to borrow at a secured borrowing rate of interest of 8 per cent. The weighted average cost of capital for investment projects of this type is 12 per cent.

1. Identify the net advantage to leasing the asset relative to purchasing it outright and recommend whether the firm should lease or buy this asset.

2. Comment on the chairmans view that the lease is attractive because the annual rental is less than the operating cash flows from the project.