Company X is investigating the acquisition of a new manufacturing plant. Two possible means of financing...

 

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Company X is investigating the acquisition of a new manufacturing plant. Two possible means of financing the plant are under consideration. Option 1: R4 million loan at 18% p.a. paid annually in arrears. The loan would be repaid in one instalment at the end of the 4th year. Option 2: Lease financing with annual instalments of R1.25 million, paid in advance over 4 years. The tax benefits of the advance lease payments would only be gained in the following year. At the end of the lease, the asset would become the property of the lessee with an estimated salvage value of R300 000 at the end of year 4. The company has consistently maintained a debt-equity ratio of 1:1, its cost of equity is estimated at 24%, and the tax rate is 30%. The plant will depreciate on a straight-line basis over 5 years. 10.1 What is the cost of owning the plant? (8) 10.2 What is the cost of leasing the plant? (4) 10.3 What recommendations would you make to management, based on the net advantage to leasing, as to the most appropriate form of finance? (1) Company X is investigating the acquisition of a new manufacturing plant. Two possible means of financing the plant are under consideration. Option 1: R4 million loan at 18% p.a. paid annually in arrears. The loan would be repaid in one instalment at the end of the 4th year. Option 2: Lease financing with annual instalments of R1.25 million, paid in advance over 4 years. The tax benefits of the advance lease payments would only be gained in the following year. At the end of the lease, the asset would become the property of the lessee with an estimated salvage value of R300 000 at the end of year 4. The company has consistently maintained a debt-equity ratio of 1:1, its cost of equity is estimated at 24%, and the tax rate is 30%. The plant will depreciate on a straight-line basis over 5 years. 10.1 What is the cost of owning the plant? (8) 10.2 What is the cost of leasing the plant? (4) 10.3 What recommendations would you make to management, based on the net advantage to leasing, as to the most appropriate form of finance? (1)

Answer rating: 100% (QA)

To determine the cost of owning the plant and the cost of leasing the plant we need to calculate the net present value NPV for each option and compare ... View the full answer