QUESTION THREE NexGuard 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 globes. 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 R175 000, 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 R75 000. The financial manager intends to exercise the option. The lessee is responsible for the maintenance and insurance costs of the manufacturing equipment which is R2000 and R900 per month respectively.

BUY: The company could purchase the machine for R400 000 cash. The current total cost for insurance and maintenance combined is R69 000 per annum while the current running costs (water and electricity) for similar machines is R50 000 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 9% 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 6% per annum starting from year two. After the three-year period, NexGuard Limited will sell the machine for R120 000.

Assume a tax rate of 28% applies and that the after-tax cost of debt is 11%

3.1 Determine the after-tax cash flows and the net present value of the cash outflows under each alternative. (23 marks) 3.2 Which alternative would you recommend? Why? (2 marks)