The Independent Institute of Education 2017

Question 6 (Marks: 40)

JLB Corporation is attempting to determine whether to lease or purchase research equipment.
The firm is in the 40% tax bracket and it’s before tax cost of debt is currently 8%. The annual end-
of-year lease payments of R25 200 are required over the 4 year life of the lease. All maintenance
cost will be paid by the lessor; insurance and other costs will be borne by the lessee. The
equipment cost R60 000 and will be depreciated straight-line to zero over four years.

You are required to;

Q.6. Calculate the after tax cash flows associated with leasing the equipment (27
1 )
Q.6. Calculate the present value of each cash flow stream using the after tax cost of (12
2 debt )
Q.6. Comment on the viability of the project (1)
3

Memorandum: Question 6 (Marks: 40)

Ref: LU 11
M.6. (27)
1
Depreciation = Depreciable Amount (2) R 60 000 (1) = R15 000
Useful Life 4

Depreciation tax shied = depreciation × tax (2) R15 000 X 0.4 = R6 000

After tax-lease payment = Lease payment X (1−tax)(2)

= R25 200 X (1 – 0.4) = R15 120

After-tax cost of debt = before tax cost of debt ×(1−tax) (2)

= 0.08 × (1 – 0.4) = 5% (1)

0 1 2 3 4
Cost of Scanner R60 000 (1)
Depreciation R15 000 R15 000 R15 000 R15 000
Depreciation (R6 000) (R6 000) (R6 000) (R6 000) (4)
tax shield
Lease Payment R25 200 25 200 R25 200 R25 200 (4)

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After tax lease (R15 120) (15 120) (R15 120) (R15 120) (4)
payment
Cash Flows R60 000 (R21 120) (R21 120) (R21 120) (R21 120) (4)

M.6. 1 2 3 4 (12)
2

Cash flows R21 120 R21 120 R21 120 R21 120
PV factors 0,952 0,907 0,864 0,823 (4)
Present value R20 160,42 R19 155,84 R18 247,68 R17 381,76 (4)

Sum of Present values = R74945.28 (2)

Net present value = R74 945.28 – R60 000 = R14 945,28 (2)

M.6. The project is viable considering that the NPV is positive (1). (1)
3

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