Option 1: In-house production The purchase and installation of the machinery shall cost $3,500,000 and has an economic life of twelve years. The machinery is expected to depreciate to zero on a straight-line basis over its economic life. However, the company expects to keep their in-house production for only seven years. At the end of Year 7, the machinery can be sold at an estimated market value of $1,700,000. Currently YDL has a warehouse which generates a rental income of $200,000 each year. To save on investment costs, the management intends to convert this warehouse into a factory for manufacturing various hardware components. The conversion cost is estimated to be $140,000 and treated as a capital expense. YDL also requires training its staff on the new machinery immediately after the installation. Training fees are expected to be $10,000 and fully tax-deductable. Annual maintenance cost of the machinery is $160,000. The collective cost of the hardware components to be manufactured is estimated to be $1,800,000 in Year 1 with an expected increase of 4% per annum in the following years. YDL also needs to invest in necessary development software and maintain the licenses. The negotiated licensing fee for the software is estimated to be $57,000 per year. Finally, the management estimates that they shall need additional net working capital of $30,000 at the beginning of the production with an expected increase of 3% per annum in the following years. Option 2: Outsourcing Alternatively, YDL can contract with a firm named Innovative Equipment Limited (IEL) which is specialised in manufacturing the required hardware. Based on the types and expected number of units YDL would need, IEL management has quoted a total cost of $3,100,000 in Year 1 which will continue to grow at 6% per annum to keep up with the rising cost and forecasted growth in the number of the required units. IEL, however, has offered this rate on a condition of a five-year contract. Also, IEL requires that YDL pays 50% of the expected cost for a year in advance at the beginning of that year. From the accounting perspective, equipment that are procured from IEL may be classified as cost of goods sold in the books of YDL. Hence, they will be treated as operating expense for the business. Furthermore, as in Option 1 YDL still needs the warehouse to store the hardware.

Evaluating Leasing Possibility

Instead of purchasing the machinery, your team, being experienced consultants, wishes to propose to YDL that they have another option which is leasing it. Coincidently, your other client, New Leasing Limited (NLL), may be a suitable lessor. On discussions, the executives at NLL have asked you to prepare a lease quotation that could be forwarded to YDL for consideration. For the purpose, NLL has provided the following information: NLL can get a 5% discount on the purchase and installation price of the machinery. They expect the life of the machinery to be twelve years with no salvage value after that. YDL may use this machinery for seven years, and NLL is confident that it can be leased to others after that. NLL uses the straight-line method for calculating depreciation. As the owner of the machinery, NLL is responsible for its annual maintenance cost. NLLs applicable tax rate is 30%. (i) If the NLLs after-tax required rate of return is 12% per annum, what will be the minimum annual lease payment that NLL would charge? Consider that NLL requires lease payments to be made annually in advance. (8 marks) (ii) Calculate the maximum annual lease payment that would make leasing a viable option for YDL? (