Aladdin plc is currently considering launching a new product. A market survey was recently undertaken at a cost of £40,000 and based on this, the following forecasts were prepared by Aladdin plc’s assistant accountant: Year 1 2 3 4 £000 £000 £000 £000 Sales 250 300 280 230 Variable costs (100) (120) (112) (92) Fixed overheads (90) (90) (90) (90) The additional information below is also relevant to this project: •

The new product will require a specialist machine to be purchased immediately at a cost of £400,000. Its estimated residual value at the end of production is £80,000 • An immediate investment of £20,000 is required for working capital, increasing to £25,000 at the end of the first year. It will be released at the end of the period. • The fixed overheads above include the annual depreciation charge for the machine. Aladdin plc depreciates all its assets on a straight-line basis. • Tax of 20% is payable one year in arrears on operating cash flows. • Capital allowances of 25% a year on a reducing balance basis are available if the machine is purchased. • The company has a cost of capital of 12%. 

Required: 

a) Calculate the Net Present Value of the project. (13 marks) 

b) Aladdin plc has the option to lease the machine at an annual rent of £100,000 for four years, payable at the start of each year. Using a pre-tax borrowing cost of 10%, recommend whether the company should lease or buy the machine. (8 marks) c) Briefly discuss the key differences between an operating lease and a finance lease. (4 marks)

Answer rating: 100% (QA)

a NPV when buying assets Year a Working notes 1 Year a 0 1 2 3 4 1 2 3 4 Year a 1 2 3 4 Year a Machi... View the full answer