QUESTION 1 (25 Marks)

Kara Limited, a South African-based Savory manufacturing company, intends to expand its output capacity in order to meet the expected increase in demand from the industry. The company plan is to acquire a new machine from China. They have the option to either lease or purchase the new machinery. The machinery has a cost of R900 000.

LEASE: The company can lease the machinery under a three-year lease. They have to make a payment of R360 000 at the end of each year. Kara Limited has the option to buy the machinery at the end of the lease for R300 000 and the financial manager intends on exercising this option. Monthly insurance costs of R12 000 are borne by the lessee.

BUY: Alternatively, the company could finance the R900 000 cost of the machinery through its retained earnings, payable upfront. Kara Limited will also pay an additional R156 000 per year for insurance costs while the current running costs (water and electricity) for similar machines are R30 000 per annum. Insurance is expected to increase by 8% per annum starting from year two. Due to improvements in the water supply and the use of renewable means of energy in the factory, running costs are expected to decrease at a rate of 10% per annum starting from year two. Depreciation is calculated using the straight-line method. Assume that the current corporate tax rate is 30% and the after-tax cost of debt is 11%.

Required: You are required to:

1.1 Determine the after-tax cash flows and the net present value of the cash outflows under each alternative. (23 marks)

1.2 Briefly indicate which alternative should be recommended. (2 marks)