Tutorial questions on Leasing
1. Trader Limited has decided to acquire additional warehouse space for storage purposes. The
firm has located an existing warehouse which is suitable and this can be either leased or
purchased. The firm can lease the warehouse for 10 years for an annual fee of R140 000
payable each year in advance. Alternatively, it can purchase the warehouse for R1 000 000.
In either case, all repairs and maintenance are the responsibility of Trader. The firm estimate
that the residual value of the warehouse at the end of the ten years will be R1 200 000.
Assume a tax rate of 28% that the cost of debt is 9.722%, and the WACC is 12%. If
purchased, the warehouse can be depreciated on straight-line basis, over 20 years.
Required:
Should the warehouse be leased on a present value analysis?
2. Maxit Ltd is considering investing in a project that will result in annual before-tax cash-flows
of R48 million per year, for 5 years. The company will need to invest in equipment which
the company can either lease or purchase.
Purchase: The cost of the equipment is R130 million and the expected residual value at
the end of 5 years is zero. The depreciation deduction is 20% per year straight-line.
Lease: The company is required to make annual lease payments of R32 million per year,
payable in advance over 5 years. The tax deduction relating to the lease payments will
occur one year after each lease payment.
The tax rate is 28%. The company’s cost of capital is 12%, whilst the after-tax cost f debt
is 7%.
Required:
What is the NPV of the project? If the NPV is positive, indicate whether the company
should lease or purchase the equipment?
3. XYZ has decided to invest in a computer-controlled measuring device costing R1.2m.
The device has an economic life span of seven years, after which no salvage value is
expected. The company must determine whether it is better to finance the acquisition
through debt or leasing. XYZ expects profits before taxes of R1m next year, R2m the
following year, R3m the third year and R4m each year thereafter (before depreciation
or leasing charges on the device). It has a high degree of confidence in these
estimates. The company has had break-even operations during the previous three
years. The company will qualify for a depreciation deduction of 40% of cost in the
first year and 20% in each of the subsequent 3 years.
If the machine is financed with debt, the National Bank is willing to extend a loan for the
full purchase price at an interest rate of 9.722%, payable in equal annual amounts over
seven years. The bank also has a leasing division and has indicated that it is willing to
provide lease finance for the acquisition of the device over the seven year period at R300
000 per annum, payable in advance. The company’s cost of capital is 11%. The tax rate
is 28%.
Required:
Should the company finance the acquisition of the device by means of the lease or the
loan?
