questions 264587

MedCo is a large manufacturing company, currently using a large printing press in its operations and is considering two replacements: the PDX341 and PDW581. The PDX341 costs £500,000 and has annual maintenance costs of £10,000 for the first five years and £15,000 for the next five years. After 10 years, the PDX341 will be scrapped (salvage value is zero). In contrast, the PDW581 can be acquired for £50,000 and requires maintenance of £30,000 a year for its 10 year life. The salvage value of the PDW581 is expected to be zero in 10 years.

Complete the following:

Assuming that MedCo must replace their current printing press (it has stopped functioning), has a 10% cost of capital and all cash flows are after tax, which replacement press is the more appropriate as calculated by using the NPV approach?

ABC Wines Company is considering the acquisition of a new irrigation system for its extensive vineyards. The system could either be bought outright for £10 million or via a finance lease requiring three annual payments in advance of £3.7 million. The leasing company is not the supplier or manufacturer of the equipment.

The new system is expected to give the following pre tax net cash savings over the existing system in use:

The system would require replacement in three years’ time and have no residual value. The outright purchase would be financed by a loan with an interest rate of 8%.

Assume that corporation tax is charged at 25% and is payable one year in arrears. Writing down allowances is available on the depreciation of the equipment. The company uses the reducing balance method for depreciation at 25%. Lease payments are allowable for tax in full.

The company has no gearing at present and a cost of capital of 13%.

Complete the following:

1. Evaluate whether ABC Wines should go ahead with the installation of the new irrigation system and whether they should use the purchase or the lease option. (Tip: You should use NPV to perform the analysis; writing down allowances should be taken into consideration.)
2. Explain the primary ways in which finance leases differ from operating leases.