QUESTION THREE $(25$ Marks$)$

MSA Limited, a manufacturing company in South Africa, is intending to expand its output capacity by acquiring a new

machine from South Korea in order to meet the expected increase in demand for energy saving globe. They are intending to

utilise the machine in production for the next three years. The company has two options they can either lease or buy the

machine.

LEASE

The company could lease the machine directly from the supplier for annual lease payments of R$255000,$ payable in

arrears. The lease term is three years and the company will have the option to purchase the machinery on termination of

the lease at a cost of R$84000.$ The financial manager intends to exercise the option. The lessee is responsible for the

maintenance and insurance costs of the manufacturing equipment which is R$2800$ and R$1100$ per month respectively.

BUY:

The company could purchase the machine for R$700000$ cash. The current total cost for insurance and maintenance

combined is R$75000$ per annum while the current running costs $($water and electricity$)$ for similar machines is R$55000$ per

annum.

Maintenance and insurance is expected to increase from year $2$ every year at the same rate of inflation which is expected to

be $8\%$ per annum. Due to improvements in the water supply and the use of renewable means of energy in the factory,

running costs are expected to decrease at a rate of $5\%$ per annum starting from year two. After the three$-$year period, MSA

Limited will sell the machine for R$150000.$

Assume a tax rate of $30\%$ applies and that the after$-$tax cost of debt is $11\%$

Required:

$3\mathrm{.}1$ Determine the after$-$tax cash flows and the net present value of the cash outflows under each alternative.

$(23$

Marks$)$

$3\mathrm{.}2$ Which alternative would you recommend? Why?