Question 11

The company Sydney Air Inc. is considering producing a new in-flight entertaining system. The marketable life of the new product is expected to be 6 years. To produce the new product, the company will have to acquire a new machine. Sydney Air Inc. can either purchase this machine for $480,000 with borrowed funds or lease it (through a finance lease contract). If the machine is purchased, it will be fully depreciated on a straight-line basis over a useful life of 6 years. The salvage value of the machine after 6 years is expected to be $100,000. If the machine is leased, the company requires to make an annual payment over the next 6 years - with payments payable in advance. Sydney Air Inc. pays tax at the rate of 35%. The required rate of return on the investment is 16% per annum after tax and the after-tax cost of debt is 11% per annum.

a) If Sydney Air Inc. is going to undertake the investment, what is the maximum lease payment that the firm is willing to pay? Show detailed workings.

b) After a detailed analysis, the NPV of the investment is calculated to be -$10,000. The CFO then concludes that as NPV < 0, the investment should NOT be undertaken. Using the approach discussed in the lecture, do you agree with the CFO? Why or why not?