Question 1

Question 1.1. (3 Marks)

SCP Limited, a silicon chip manufactory and designer, is facing increased competition in the market and needs to urgently raise cash to fund strategically important R&D programmes and develop new processors. The company already sold off some of its foundries and already only keeps the minimum capabilities to prototype new chips in-house which is critical to have in the industry. A layoff process has already run its course and the management of the company does not believe that there are any obvious benefits from any further cost cutting on the table. The assets that the company do still have are highly specialised and expensive but a liquid secondary market for them does not exist, with many of the assets being required for ongoing development in any case. The company does however own a large and expensive office block which can be considered its only non-specialised asset that a liquid market exists for. Lenders are not willing to offer more funds to the company owing to it being considered over-levered in the market already and the company is keeping a rights issue as an absolute last resort as its shares are trading for only 2c apiece in the markets and a rights issue would send a message for impeding bankruptcy and is not expected to even be fully subscribed. Preference shares are also not an option as the company has covenants prohibiting it from issuing new ones till its debt ratio recedes. The company is not making a large annual loss at the moment, however, its retained earnings have also been depleted. The management of the company is confident that a recent spate of hires of exceptionally talented and experienced engineers will lead to it being able to turn the company around, but, cash is needed to fund the R&D programme and finish the development and prototyping and ordering a first batch of new processors that are expected to turn the fortunes of the company around.

Required:

Considering the situation SCP Limited finds itself, how could the company raise cash to complete its R&D and development processes? Please keep your answer to one sentence (max two or three lines of normal size text, anything longer will not be marked).

Question 1.2 (12 Marks)

Socks Ltd manufactures socks and legwarmers and wants to expand its product line. The management of the company has indicated that a new machine is required to manufacture a new line of brightly coloured socks. To purchase the machine, it has negotiated financing with a favourable before tax cost of 3% interest per annum with equal annual instalments. Alternatively, the company can enter into a direct financial lease with the manufacturer of the machine, which means that the manufacturer will offer the machine and maintenance on it for the useful life of the machine at a cost of R 300 000 per year, paid at the start of each year for three years.

The machine costs R 600 000 and it is expected that it will require maintenance of R 80 000 per year, if bought. It is also expected that the machine can be sold for R 100 000 at the end of its useful life of three years. The machine can be depreciated by way of the straight-line method over a period of three years.

A tax rate of 28% is applicable. The company has a before tax cost of debt of 11%.

Required:

Determine the net advantage of leasing and advise the company on the option they should take based on your findings.