QUESTION ONE

Due to the strain on electricity demand in Cape Town during the cold winter months, Max Steel Limited an iron, steel and aluminum manufacturing company require a new generator costing R458 000. The company has the option to either lease or own the generator.

Cost of leasing:

The lease would require annual end of year payments of R125 550 over the four years. Service and insurance costs of R500 per month will be borne by the lessee. The lessee will exercise its option to purchase the asset for R180 000 at the termination of the lease in four years.

Cost of owning:

Max Steel Limited could alternatively purchase the new generator for R458 000 cash. This would result in maintenance expenses of R12 000 per annum. Depreciation charges are based on the straight-line method. At the end of the period the generator will be sold at its residual value of R50 000.

The company is in the 28% tax bracket and the after-tax cost of the debt is 15%.

1.1 Determine the after-tax cash outflows and the net present value of the cash outflows under each alternative. Show all calculations (22 marks)

1.2 Which alternative would you recommend? Briefly explain. (3 marks)