Kariba Bream Fisheries

Kariba Bream Fisheries (hereinafter referred to as 'KB Fisheries') is a large and profitable company that breeds, processes and markets a brand of canned fish. The management of KB Fisheries is keen to expand and is consistently on the lookout for suitable investment opportunities.

In the past, KB Fisheries has always used an outside firm to do the canning for them, at a cost of R1.80 per can. However, a new mini-canning plant has just been released on the market, and the management of KB Fisheries is keen to establish whether it is better to acquire the canning plant, rather than use the services of the outside firm.

The canning plant will cost R2.4 million, and will qualify for a depreciation deduction of 40% of cost in the first year and 20% of cost in each of the subsequent three years. The plant is expected to have a useful life of five years, at the end of which it is expected to be sold for R400 000.

KB Fisheries' production manager estimates that a total of 720 000 cans will be processed each year for the five years. If the plant is purchased, KB Fisheries will incur maintenance and insurance costs amounting to R80 000 per annum. Other expenses, which will be incurred whether the asset is leased or purchased, will amount to R0.35 per can.

KB Fisheries is able to finance the acquisition of the plant through either a lease agreement or a loan from its bank.

Lease:

KB Fisheries can lease the plant from a plant manufacturer at an annual cost of R520 000. The lease payment will be made at the beginning of each year. Under the lease agreement, the manufacturer will be responsible for the maintenance and insurance of the plant.

Purchase:

KB Fisheries can finance the cost of the plant through a five-year bank loan at an interest rate of 11.111%. The loan will be repaid in equal annual instalments.

Assume a company tax rate of 28%. KB Fisheries' weighted average cost of capital is 15%.

Source: adapted from Correia, C. 2019. Financial Management. 9th ed. Cape Town: Juta and Company (Pty) Ltd.

1.1 Employing a net present value (NPV) analysis, advise management whether they should proceed with the investment in the canning plant or continue using the outside canning firm.

1.2 Assuming that the NPV obtained in Question 1.1 is positive, advise management whether they should lease or purchase the plant, based purely on numerical calculations.

1.3 Why would it be in the best interests of KB Fisheries to purchase the plant, even if leasing is the cheaper option?