Question 4

(Capital budgeting, lease vs. purchase)

Fishcakes Ltd wants to expand its operations, as it is experiencing rapid growth. The company needs to obtain a fish de-scaler urgently in order to meet the increased demand. It has access to debt at an after-tax cost of 8% (which is also the company's after-tax cost of debt in terms of its capital structure), which it can use to borrow and buy the machine. 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.

The machine costs R600 000 and it is expected that it will require maintenance of R20 000 per year, if bought. It is also expected that the machine can be sold for R150 000 at the end of its useful life of five years. The machine can be depreciated by way of the straight line method over a period of five years. A tax rate of 28% is applicable.

The lease will cost R150 000 per year, paid at the end of every year for five years.

REQUIRED

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