AGD Co (FMC, 12/05, amended)
AGD Co is a profitable company which is considering the purchase of a machine costing $320,000. If purchased, AGD Co would incur annual maintenance costs of $25,000. The machine would be used for 3 years and at the end of this period would be sold for $50,000. Alternatively, the machine could be obtained under a 3-year lease for an annual lease rental of $120,000 per year, payable in advance. The lease agreement would also provide insurance and maintenance for a three-year period. The lease also contains an annual break clause allowing the lease to be exited at the lessee's discretion.
AGD Co can claim tax-allowable depreciation on a 25% reducing balance basis. The company pays tax on profits at an annual rate of 30% and all tax liabilities are paid one year in arrears. AGD Co has an accounting year that ends on 31 December. If the machine is purchased, payment will be made in January of the first year of operation. If leased, annual lease rentals will be paid in January of each year of operation.
A. Using an after-tax borrowing rate of 7%, evaluate whether AGD Co should purchase or lease the new machine.
B. Discuss whether the lease may also provide non-financial benefits.
C. Explain the difference between risk and uncertainty in the context of investment appraisal.