GoCold Plc is considering an investment in new technology that will reduce operating costs through increasing energy efficiency and decreasing pollution. The new technology will cost $1 million and have a four‐year life, at the end of which it will have a scrap value of $100,000.

A licence fee of $104,000 is payable at the end of the first year. This licence fee will increase by 4% per year in each subsequent year.

The new technology is expected to reduce operating costs by $5.80 per unit in current price terms. This reduction in operating costs is before taking account of expected inflation of 5% per year.

Forecast production volumes over the life of the new technology are expected to be as follows:

Year 1 2 3 4

Production (units per year) 60,000 75,000 95,000 80,000

If GoCold Plc bought the new technology, it would finance the purchase through a four‐year loan paying interest at an annual before‐tax rate of 8.6% per year.

Alternatively, GoCold Plc could lease the new technology. The company would pay four annual lease rentals of $380,000 per year, payable in advance at the start of each year. The annual lease rentals include the cost of the licence fee.

If GoCold Plc buys the new technology, it can claim tax allowable depreciation on the investment on a 25% reducing balance basis. The company pays taxation one year in arrears at an annual rate of 30%. GoCold Plc has an after‐tax weighted average cost of capital of 11% per year.

Required:

(a) Based on financing cash flows only, calculate and determine whether GoCold Plc should lease or buy the new technology.

(b) Using a nominal terms approach, calculate the net present value of buying the new technology and advise whether GoCold Plc should undertake the proposed investment.

Answer rating: 100% (QA)

a Based on financing cash flows only calculate and determine whether GoCold Plc should lease or buy the new technology To decide whether to lease or buy the new technology based on financing cash flows we need to calculate the present value of the cash flows for each option If GoCold Plc buys the new technology the cash flows are as follows Year 0 1000000 initial investment Year 14 274250 loan interest payments calculated as 86 of the outstanding loan balance Year 1 104000 licence fee payment Year 14 174750 tax shield on depreciation calculated as 30 of the depreciation charge of 25 of the net book value at the beginning of the year Year 4 100000 scrap value To calculate the net present value of buying the new technology we discount each cash flow ... View the full answer