Advanced financial management revision question and answer

Advanced Financial Management Block Revision Mock Exams

Your firm is considering the acquisition of a new fork lift truck. It is uncertain about whether to purchase the truck outright or to finance it through a leasing arrangement with Kasneb Bank Ltd. The purchase price is Sh.5,200,000 and it will have a salvage value of Sh.400,000 at the end of its 8-year useful life. The annual lease cost would be Sh.996,000 for 8 years.

The company uses the straight-line method for analysis investment decisions.
The company can borrow funds (to purchase the forklift) at 22% and it has an effective tax rate of 35%. Its after tax cost of capital is 12%.

Required:
a) Analyse the decision situation and advise the firm about the appropriate acquisition method.

b) If the company could get a 20% investment allowance on this investment, how would this affect your answer in (a) above?
answer
a) Leasing Option

A 20% investment allowance would lead to additional tax shield in addition to the depreciation tax

Assuming the allowance is granted at end of year 1, the P.V of the tax shield would be 364,000 x PVAF14.3%,1 = 364,000 x 0.875 = 381,500

This would reduce the net cost of buying new cost = (4,098,270) + 318,500 = (3,779,770)

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