CORPORATE FINANCE II TUTORIALS

QUESTIONS FOR TUTORIALS

TOPIC: LEASE FINANCING

Question 1

1. What is leasing? Define, compare and contrast operating lease and financial (or capital) lease.
2. Describe the four basic steps involved in the lease-versus-purchase decision process. How are
capital budgeting methods applied in this process?
3. What type of lease must be treated as a capitalised lease on the balance sheet? How does the
financial manager capitalise the lease?
4. List and discuss the commonly cited advantages and disadvantages that should be considered
when deciding whether to lease or purchase.

5. The Dean of the Faculty of Commerce is contemplating commercialising Delta Theatre. First of all
he determines that there is need to set up a virtual learning link with the University of Cape
Town. Acquisition of the system will cost $48 000. But the supplier has offered to lease the
equipment to NUST, if they prefer a lease over a purchase. NUST would pay taxes at 40%.
 The Lessor has offered the following terms: the Faculty would obtain a 5-year lease requiring
annual end-of-year lease payments of $12 000. All the maintenance costs would be paid by
the lessor, and insurance and other cost would be borne by the lessee. The lessee would
exercise its option to purchase the machine for $8000 at termination of the lease.
 The Faculty could also finance the purchase of the equipment with a 9%, five year loan
requiring end of year instalment payments of $12 340. The equipment would be deprecated
using a five year recovery period at 20% per year. The Faculty would pay $3 000 per year for
a service contract that covers all maintenance costs; insurance and other costs would be
borne by the lessee. The Faculty plans to keep the equipment and use it beyond its 5-year
recovery period.

Required.
a) You have just graduated with a BCom Finance (Hons), and you are now employed in the
Faculty Office and the Dean has tasked you to prepare a proposal on whether he should
decide to lease or buy the equipment.
b) Recalculate and decide whether to lease or buy if the following has changed:
 The lease payments are made at the beginning of the year;
 The faculty’s policy is to depreciate the full value of all electronic equipment over 4
years straight line;
 The faculty decides to sell the equipment they buy it from for $12000 soon after the
lessor.

6. The Hot Bread Shop wishes to evaluate two plans, leasing and borrowing to purchase an oven.
The firm is in the 40% tax bracket.
 lease
The shop can lease the oven under a 5-year lease requiring annual end-of-year
payments of $5 000. All maintenance costs will be paid by the lessor, and insurance and
other costs will be borne by the lessee. The lessee will exercise its option to purchase
the asset for $4 000 at termination of lease.

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CORPORATE FINANCE II TUTORIALS
QUESTIONS FOR TUTORIALS

TOPIC: LEASE FINANCING

 Purchase
The oven costs $20 000 and will have a 5-year life. It will be depreciated at 20% per year,
and it is estimated that the asset will have a residual value of $10 000 at the end of the 5
year period. The total purchase price will be financed by a 5-year, 15% loan requiring
equal annual end-of-year payments of $5 967. The Hot Bread Shop will pay $1 000 per
year for a service contract that covers all maintenance costs. Insurance and other costs
will be borne by the Hot Bread Shop. The firm plans to keep the equipment and use it
beyond its 5-year recovery period.

REQUIRED

(a) For the lease plan, calculate the following:

(i) the after-tax cash outflow each year
(ii) the present value of the cash flows, using a 9% discount rate

(b) For the purchase plan, calculate the following:

(i) The annual interest expense deductable for each of the years
(ii) The after-tax cash outflow resulting from the purchase for each of the years.
(iii) The present value of the cash flows using a discount rate of 9% per year

(c) Com pare the present values of the cash outflow streams for these two plans,
and determine which plan will be preferable. Explain your answer.

7. Omnia Ltd proposes to acquire a new piece of machinery costing $80 000. It will have a useful
life of five years, at the end of which it can be sold for $12 000. The company is looking at the
following financing alternatives which are available:
(1) Buy the machinery with a bank loan at an interest rate of 11,5 percent.
(2) Lease the machinery for five years at a lease rental of $18 000, payable at the end of each
year. Omnia's weighted average cost of capital (WACC) is 16 percent and tax is payable at the
rate of 43 percent with a lag of one year. No other tax concessions are available. The after-tax
cost of funds may be rounded to the nearest full number.

REQUIRED
Set out a table of relevant cash flows, and assess which of the proposed methods of financing
would be beneficial for Omnia Ltd. Note: Please show all calculations.