Advanced financial management revision question and answer

Gathura Ltd. is evaluating the acquisition of a heady duty forklit. The company can either purchase the equipment through the use of its normal financing mix (30% debt and 70% equity) or lease it.

The following additional information is available:

1. Acquisition price Sh.8,000,000
2. Useful life 4 years
3. Salvage value Sh.1,600,000
Depreciation method – straight line
Annual (before tax and depreciation) cash savings Sh.2,400,000 Rate of interest on a four year period 10%
Marginal tax rate 10%
Annual lease rentals Sh.2,400,000

Annual operating expenses Sh. 400,000
Cost of capital 12%

Required:
i) Evaluate whether acquisition of the forklift through purchase is justified.
ii) Should Gathura Ltd. lease the asset?

answer
i)To justify the acquisition, the investment decision has to be made using NPV analysis.


Where D.T.S = depreciation tax shield = depreciation p.a. x tax rate.

Therefore net operating cash flows

The acquisition is not justified.

b) ii)Should the company lease the asset?
Evaluate the decision from lease or buy decision perspective.

If the asset is leased, then after tax annual lease rentals = 2.4M(1 – 0.3) 1.680M p.a. rate = after tax cost of debt 10%(1-0.3) = 7%.

PV of lease rentals = 1.680 x PVAF7%,4 = 1.680 x 3.387 = 5.69M

If the asset is acquired, then:


Note:
Since the after tax cost of borrowing is the discounting, the tax benefit/shield of interest charges is already incorporated in the after tax cost of debt.

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