Question (19 marks)

Metropolitan Limited, a construction company, is planning to acquire new earthmoving equipment at a cost of $10 million, and is considering the following alternative sources of finance:

(i) A bank loan for the full cost of the equipment, repayable over four years in equal annual instalments incorporating interest at a rate of 5% per annum, with the first instalment to be paid one year from the date of taking out the loan. Assume that interest is calculated on beginning balance of loan for each period.

(ii) A lease with four annual lease payment of $275,000, payable at the beginning of each year.

The equipment will have no residual value at the end of four years.

Required:

(a) Calculate the annual instalment that would be payable under the bank loan. Also calculate how much would represent the principal repayment and how much would represent interest charges in each of the four years and in total. (8 marks)

(b) The CFO of Metropolitan has a friend visiting from overseas, who has advised that it would be preferable to lease the equipment rather than buying it. The friends argument is that leasing would avoid Metropolitans own capital being locked up, since it would be the lessor who would buy and own the equipment. Metropolitan Ltd. is highly leveraged, and the friend has also suggested that leasing the equipment instead of borrowing to buy it would make Metropolitans balance sheet look better. Discuss/critique the advice offered by the friend. (6 marks)

(c) Discuss possible advantages to companies like Metropolitan of leasing the equipment rather than buying it with a bank loan. (5 marks)