QUESTION 1: Buying vs Leasing

ASOP Co is considering an investment in new technology that will reduce operating

costs
through increasing energy efficiency and decreasing pollution. The new technology will
cost RM1 million and have a four-year life, at the end of which it will have a scrap value
of RM100,000.

A license fee of RM104,000 is payable at the end of the first year. This license fee will
increase by 4% per year in each subsequent year.

The new technology is expected to reduce operating costs by RM5.80 per unit in current
price terms. This reduction in operating costs is before taking account of expected
inflation of 5% per year.

Forecast production volumes over the life of the new technology are expected to be as
follows:
Year 1 2 3 4
Production (units per year) 60,000 75,000 95,000 80,000

If ASOP Co bought the new technology, it would finance the purchase through a four-
year loan paying interest at an annual before-tax rate of 8.6% per year.

Alternatively, ASOP Co could lease the new technology. The company would pay four
annual lease rentals of RM380,000 per year, payable in advance at the start of each
year. The annual lease rentals include the cost of the license fee. If ASOP Co buys the
new technology it can claim tax allowable depreciation on the investment on a 25%
reducing balance basis. The company pays taxation one year in arrears at an annual
rate of 30%.

ASOP Co has an after-tax weighted average cost of capital of 11% per year.

Required:

(a) Based on financing cash flows only, calculate and determine whether ASOP Co should
lease or buy the new technology.

(b) Using a nominal terms approach, calculate the net present value of buying the new
technology and advise whether ASOP Co should undertake the proposed investment.

(c) Discuss and illustrate how ASOP Co can use equivalent annual cost or equivalent
annual benefit to choose between new technologies with different expected lives.

QUESTION 2: Replacing vs Overhaul

After securing an extension to an existing contract, the directors of Dairy Co are

reviewing the options relating to a machine that is a key part of the company’s
production process.

Option 1 – Replace the machine

The cost of a new machine would be RM450,000, payable immediately.
Maintenance costs would be payable at the end of each year of the project. The first
maintenance payment for the new machine is RM25,000 although this is expected to
rise by 7.5% per year.

Option 2 – Overhaul the existing machine

The alternative to replacement is a complete overhaul of an existing machine, the cost
of which would be RM275,000, also payable immediately. This would be classified as
capital expenditure. However, under this option, the annual maintenance costs will be
higher at RM40,000 in year 1 with expected annual increases of 10.5%.

As the new machine is likely to reduce the variable cost, the contribution will be different
depending on which machine is used. The contribution from each machine (excluding
maintenance costs) is tabulated as follows, with the inflow of funds assumed to be at the
end of each year:

Year (RM) Year 1 Year 2 Year 3 Year 4 Year 5

Contrib. with new machine 150,000 170,000 190,000 210,000 220,000
Contrib. with overhauled machine 130,000 145,000 155,000 160,000 160,000

The financial manager is unsure of the cost of capital, but expects it is around 12%.
Taxation can be ignored.

Required:

(a) Calculate the net present value of each option.

(b) Estimate the internal rate of return of each plan.

(c) Interpret the results that you have obtained in parts (a) and (b) above, and
recommend which alternative should be chosen.

(d) Explain the different roles of a treasury department and a finance department in the
context of a new investment, and discuss the need for close liaison between the two
departments.