32. JAVA Co
JAVA Co. is a small company that is finding it difficult to raise funds to acquire a new machine costing $750,000. JAVA Co would ideally like a four-year loan for the full purchase price at a before interest tax rate of 8.6% per year.
The machine would have an expected life of four years. At the end of this period the machine would have a residual value of $50,000. Tax-allowable servicing costs for the machine would be $23,000 per year. Tax-allowable depreciation on the full purchase price would be available on a 25% reducing balance basis.
A leasing company has offered a contract whereby JAVA Co could have use of the new machine for four years in exchange for an annual lease rental payment of $200,000 payable at the start of each year. The contract states that the leasing company would undertake maintenance of the machine at no additional cost to JAVA Co. At the end of four years the leasing company would remove the machine from the manufacturing facility of JAVA Co.
JAVA Co pays corporation tax of 30% one year in arrears.
Required
A. For the new machine:
(i) Calculate the present value of the cost of borrowing to buy.
(ii) Calculate the present value of the cost of leasing.
(iii) Recommend which option is more attractive in financial terms to JAVA Co.
(a) (i) Present value of the cost of borrowing to buy
After-tax cost of borrowing = 8.6 x (1 – 0.3) = 8.6 x 0.7 = 6%
Calculating PV of cost of borrowing to buy:
Year |
0 |
1 |
2 |
3 |
4 |
5 |
|
$ |
$ |
$ |
$ |
$ |
$ |
Purchase |
(750,000) |
|
|
|
|
|
Residual value |
|
|
|
|
50,000 |
|
Service costs |
(23,000) |
(23,000) |
(23,000) |
(23,000) |
(23,000) |
|
TAD benefit |
|
|
56,250 |
42,188 |
31,641 |
79,922 |
Service cost tax benefits |
|
|
6,900 |
6,900 |
6,900 |
6,900 |
Net cash flow |
(750,000) |
(23,000) |
40,150 |
26,088 |
65,541 |
86,822 |
Discount at 6% |
1.000 |
0.943 |
0.890 |
0.840 |
0.792 |
0.747 |
|
(750,000) |
(21,689) |
35,734 |
21,914 |
51,908 |
64,856 |
PV of cost of borrowing to buy is $597,777.
Using the spreadsheet NPV function and spreadsheet-calculated discount factors, PV of cost of borrowing to buy is $597,268.
Working: TAD benefit
Year |
0 |
1 |
2 |
3 |
4 |
5 |
|
$ |
$ |
$ |
$ |
$ |
$ |
Purchase |
750,000 |
|
|
|
|
|
TAD |
|
187,500 |
140,625 |
105,469 |
266,406 * |
|
30% TAD benefit |
|
|
56,250 |
42,188 |
31,641 |
79,922 |
*750,000 – 187,500 – 140,625 – 105,469 – 50,000 = $266,406
(ii) Calculating PV of cost of leasing:
Year |
0 |
1 |
2 |
3 |
4 |
5 |
|
$ |
$ |
$ |
$ |
$ |
$ |
Lease rentals |
(200,000) |
(200,000) |
(200,000) |
(200,000) |
|
|
Tax benefits |
|
|
60,000 |
60,000 |
60,000 |
60,000 |
Net cash flow |
(200,000) |
(200,000) |
(140,000) |
(140,000) |
60,000 |
60,000 |
Discount at 6% |
1.000 |
0.943 |
0.890 |
0.840 |
0.792 |
0.747 |
|
(200,000) |
(188,600) |
(124,600) |
(117,600) |
47,520 |
44,820 |
PV of cost of leasing is $538,460.
Using the spreadsheet NPV function and spreadsheet-calculated discount factors, PV of cost of leasing is $538,464.
(iii) Recommendation
Financial benefit of leasing = $597,277 – $538,460 = $58,817
Using the spreadsheet NPV function and spreadsheet-calculated discount factors, financial benefit of leasing = $597,268 – $538,464 = $58,804.
Leasing the new machine is recommended as the option which is more attractive in financial terms to JAVA Co.