Lucketts Travel is a family-owned transport company based in Fareham, Hampshire, UK with a fleet of over 130 vehicles. In 2021, the revenue for the company was 65 million and earnings of 145 million. The directors of Lucketts have been evaluating the possibility of replacing of a number of vehicles, which will be purchased from Volvo in Sweden. The vehicles will have a capital cost of SEK16 million and the directors expect these new vehicles to provide after-tax cash flow benefits (including tax depreciation benefits) of 160,000 each year. Cash flows beyond five years are ignored by Lucketts travel in all its investment decisions. The vehicles are estimated to have a resale value at the end of five years of 15% of the original purchase price. Lucketts travel is currently financed totally with equity. Some directors believe this should continue and the new vehicles should be financed with a rights issue (that is, they are prepared to inject more capital into the business themselves). However, the Chief Executive has suggested that this capital structure fails to take advantage of the tax benefits of debt and has requested the management accountant to evaluate two methods of that the company can use to finance the new vehicles.

The two financing options are:

1. The company has the option of securing a debt to finance the purchase of the vehicles. This debt is expected to be repaid in five years' time. The current after-tax rate of interest in the UK for any debt is 6% per annum. Interest payments would be made at the end of each year.
2. Lucketts travel also has another option of lease from Volvo Sweden where the vehicles will be supplied and the company is estimated to pay Volvo in five annual payments of SEK320,000 payable at the beginning of each year. Lucketts travel has the option to buy the vehicles from Volvo at the end of the lease contract for a nominal amount of SEK1. Assume the whole amount of each annual payment is tax deductible.

You are also provided with other information relevant to the decision is as follows:

• The discount rate that Lucketts travel applies to replacement investment decisions is 12%;
• Lucketts travel marginal rate of tax is 35%. This rate is not expected to change in the foreseeable future. Tax is payable in the year in which the liability arises and tax depreciation allowances are available at 25% per annum on a reducing balance basis;
• Assume that the spot rate of SEK to the is 245;

Required:

1. Evaluate the investment in Pound sterling () using NPV and advise management which option between debt repayable in five years' time or a finance lease is cheapest for the company. Assume all cash flows and interest rates given in the question are in nominal terms. (14 marks)
2. Assume that management of the company has restrictions on how much to invest, advise the CEO of Lucketts travel on the advantages and disadvantages of the company financing the vehicles with debt or a finance lease compared with new equity raised via a rights issue. (6 marks)

Total [20 marks]