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 fouryear 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. Taxallowable servicing costs for the machine would be $23,000 per year. Taxallowable 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
Aftertax 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 spreadsheetcalculated 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 spreadsheetcalculated 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 spreadsheetcalculated 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.