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 5year 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 facultys policy is to depreciate the full value of all electronic
equipment over 4 years straight line;
The faculty decides to sell the equipment 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.

CORPORATE FINANCE II TUTORIALS

QUESTIONS FOR TUTORIALS
TOPIC: LEASE FINANCING
The lessee will exercise its option to purchase the asset for $4 000 at
termination of lease.
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) Compare 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.