In the given case the company Yarra Digital Limited is planning for up-gradation of its process for which there are two options, one being in-house production and other to outsource it. In the option of in-house production the requirement of the machinery is there. Thus the consultants have proposed two options for acquiring machinery one being purchase of the machinery and other taking the machinery on lease. The consultants have also proposed a lessor of machinery. Thus the suitability of the lease option is discussed. The lessor is the New Lease Limited (NLL). The suitability of the option with regard to the Lessor is shown in part 1 of the solution.
The required rate of return of the lessor is given as 12% per annum and annual lease payments are required to be received in advance. Thus the discounting rate use for a solution is taken as 12% is the required rate of return. All the cash inflows and outflows are discounted to present value using this discount rate. The initial outflow of the cash will be due to the purchase of the machinery and thereafter the maintenance cost is also be incurred by the company. As the machinery will be given for the part life of the machinery this will be regarded as the financing lease and thus the depreciation will be charged by the lessor. The calculation of the minimum lease payments as required by the company will be done after taking into consideration the purchase cost, maintenance cost, and depreciation benefit on the machine. All these cash flows will be taken after the tax effect of 30% as applicable to the company.
The actual cost of the machinery was $3,500,000 with the economic life of the asset being 12 years. The lessor will be able to get the asset at a discount of 5% which is at $3,325,000. Though the machinery required by the Yarra is only for 7 years the life of the machinery is 12 years and the lessor will be able to lease it to other after the end of the 7 years thus the depreciation charged by the company is done on full 7 years at straight-line method over the life of the asset. Since there is no salvage value of the machinery the depreciation is calculated by dividing the cost by the economic life coming as $277,083.33 per year. Since this is not the actual cash outflow but due to this we get the tax benefit thus in the present value calculation only the tax shield or benefit on depreciation is taken into consideration being 30% of depreciation as $ 83,125.
The annual maintenance cost of the machinery is $160,000, thus after-tax the cost is coming as $112,000(160,000*70%). The cumulated present value factor at the rate of 12% for 11 years and 12 years is coming as 5.94 and 6.19 respectively. As the lease rental is received in advance the first installment is required to be paid immediately and the present value of the remaining 11 installments will be 5.94 times of the annual lease payments. Thus the present value of total lease payments is 6.94 (1+5.94) times the annual lease payments. This will be compared with the initial cost of machinery, annual maintenance cost and tax benefit on depreciation to arrive at an annual lease payment of $504,861.10.
The above calculation was done only considering the lessor now the option should be equally viable for the Yarra to be accepted. Thus we further calculate the maximum annual lease payments the Company is willing to pay. In the given case the calculation will be done for 7 years only after seven years the company will sell the machinery at $1,700,000. The cost of the machinery to the company will be $3,500,000 as no discount will be available. Thus the depreciation will be calculated at $1,800,000 (3500000-1700000). As the machinery is purchased the depreciation and maintenance cost will be incurred by the company. The tax rate is 30% and all cash flows are taken after tax and instead of depreciation the tax shield on depreciation is taken in the calculation.
Thus the cumulative present value factor at 12% for 6 and 7 years is coming as 4.11 and 4.56 respectively. The lease rentals will be paid for 7 years in advance thus the one installment is payable immediately and the present value of the remaining 6 installments will be 4.11 times the annual lease payments, thus the total annual payments present value will be 5.11 times of annual payment. This will be compared with the present value of the cost of machinery, annual maintenance cost, and residual value also adjusting the present value of the annual tax benefit of the depreciation. Thus the maximum lease rental payment by the YDL is coming as a $566,330.44 annual lease in advance.
Thus the negotiation between the parties can be done and arrive at a figure where both the party agrees the lease can materialize. As the minimum lease required by the NLL is less than the maximum payment that can be done by the YDL the lease option is beneficial for both the company.
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