Strauss Logistics is a UK transportation company. They deliver goods to supermarket warehouses on behalf of a range of suppliers. Business has been good and the company wishes to upgrade its fleet of delivery lorries. They have a request from the operations manager for 30 new vehicles to allow the company to meet the anticipated growth in demand over the next two to three years without suffering blocks to deliveries. The existing fleet is of varying ages and the older vehicles are spending longer in the garages being patched up to stay on the road a bit longer. The reliability of the fleet will become an issue shortly if nothing is done about it.
The finance director runs a tight ship when it comes to spending the company’s cash flow. So he is looking for any deals he can get to shave something off the cost of the new vehicles. He has been deliberating between borrowing to buy the fleet of 30 lorries and leasing the new fleet.
The new lorries that are available make some of the current fleets look almost prehistoric. They all have the latest electronic aids on board and the comfort and safety of the driver have been given a very high priority, with advanced sleepiness monitors for the cabins to detect when the drivers should take a rest.
The lorries would cost £120,000 each if bought and they would be depreciated on a straight line basis down to a salvage value of £25,000 over 5 years. This accounting depreciation figure will be the one used for tax purposes. This is the average price that the leasing company thinks they would be able to sell them for at the end of the lease. The lessor would charge Strauss £28,000 per year for the lease of each lorry. The lessor would pay for the servicing of the lorries on an annual basis. Strauss estimates this would have cost them £750 per vehicle to do each year. The lease payments would start at the commencement of the lease for six payments.
The debt rate for Strauss is 11.43% and debt makes up 30% of Strauss’s capital structure. The tax rate is 30%, the equity risk premium is 6% and the risk free rate is 4.5%. Strauss has an equity beta of 1.3.

Lay out the cash flows to support the lease or borrow to buy decision, and calculate which option is preferable? Show your cost of capital calculations.

Answer rating: 100% (QA)

Solution Cost of Debt Kd 1143 070 800 Cost of Equity Ke Rf RmRfBeta 450 6 130 1230 Cost of Capital W... View the full answer