Groundup (Pty) Ltd, a South African construction company, is planning to acquire new earth-moving equipment at a cost of R50 million, and is considering how to finance the acquisition. The company can either lease or purchase the equipment. The following information relates to these two options.

Purchase

The company can purchase the equipment through a bank loan for the full cost of the equipment. Interest on the loan will be charged at a rate of 12.50% per annum.

The equipment qualifies for a depreciation deduction of 40% of cost in the first year, and 20% of cost in each year for the subsequent three years. The equipment is expected to have a useful life of ten years. However, GroundUp (Pty) Ltd intends to use the equipment for five years, at the end of which it expects to dispose of the equipment for a third of its cost.

If the company purchases the equipment, it will spend R1.5 million per year on insurance and maintenance costs.

Lease

The company can lease the equipment at an annual lease rental cost of R15 million, payable in advance over five years. The tax deduction relating to the lease payments will occur at the end of each year. Under the lease agreement, the lessor will be responsible for the insurance and maintenance of the equipment.

The Chief Executive Officer (CEO) has a friend visiting from abroad, who has advised that it would be preferable to lease the equipment rather than buy it. The friend's argument is that leasing would prevent GroundUp (Pty) Ltd's own capital being tied up, since it would be the lessor who would buy and own the equipment.

GroundUp (Pty) Ltd is highly geared, and the friend has also suggested that leasing the equipment instead of buying it would make GroundUp (Pty) Ltd's balance sheet look better. As an example of the convenience of leasing, the friend points to the rental car that they have been using while visiting South Africa.

The corporate tax rate is 28%.

2.1 What type of lease is GroundUp (Pty) Ltd being offered?

2.2 Evaluate whether GroundUp (Pty) Ltd should lease or buy the equipment.

2.3 Discuss the soundness/relevance of the advice offered by the CEO's friend.

2.4 Taking into consideration your answer to Question 2.2 above, discuss any two possible advantages to a company like GroundUp (Pty) Ltd of leasing the equipment, rather than acquiring it with a bank loan.