340 FINANCIAL PERFORMANCE &RISK; ANALYSIS Question 4 (12 Marks) Crikey Led requi

Question

340 FINANCIAL PERFORMANCE &RISK; ANALYSIS Question 4 (12 Marks) Crikey Led requires a heavy duty truck for six months from Ist January. Based on the following information, advise the company on whether to purchase or lease the truck Data: The truck can be purchased new for $200,000 and has an effective life offive years. Resale value of the truck at the end of the six months is estimated at $160,000. If purchased, the annual insurance premium for the truck would be $12,000 payable in advance. If sold prior to the end of the twelve months, a proportionate refund would be obtained. At the end of the fourth month a general overhaul would cost $7,000 Monthly Repairs&Maintenance; during the first three months would cost $1,000 per month. No R&M; in the fourth month due to overhaul but subsequent monthly costs to be $2,000 per month. 'I he company tax rate is 30%. The company's cost ofcapital is 12% p. a. · A leasing contract is considered whereby the monthly lease payments of $12,000 are payable at the commencement of each month for the six months. . All tax effects are in June. . Ifthe truck is leased, the insurance, repairs and maintenance and general overhaul would be paid by the lessor. Depreciation to be calculated on a straight line basis. · .

Explanation / Answer

OPTION : PURCHASE Initial cost $200,000 Payment of annual insurance $12,000 Total Initial cost $212,000 T Resal value after six months $160,000 Payment of annual insurance $12,000 Refund of insurance after six months $6,000 Terminal cash flow(160000+6000) $166,000 Cost of overhaul at the end of 4th month $7,000 Monthly R&M during month 1,2,3 $1,000 Monthly R&M during month 4 $0 Monthly R&M during month 5&6 $2,000 Tax rate 30% Cost of capital 12% Effective life in years                         5 Depreciation (assuming straightline method) 20000 (200000/5)*(6/12) Depreciation tax shield $            6,000 (20000*0.3) Present Valie (PV ) of cash flow=(Cash flow)/((1+i)^N) i=interest rate for the period(Month)=(12/12)=1%=0.01 N=Period of cash flow Monthwise cash flow and PV of cash flow are given below: N A B C D=A+B+C E=D/(1.01^N) Month Cash outflow Terminal Cashflow Depreciation tax shield Net Cash outflow PV of cashflow 0 $212,000 $0 $0 $212,000 212000 1 $1,000 $0 $0 $1,000 990.0990099 2 $1,000 $0 $0 $1,000 980.2960494 3 $1,000 $0 $0 $1,000 970.5901479 4 $7,000 $0 $0 $7,000 6726.862411 5 $2,000 $0 $0 $2,000 1902.931375 6 $2,000 ($166,000) ($6,000) ($170,000) -160147.69 TOTAL 63423.089 Present Value of cost of owning $          63,423 OPTION : LEASE Monthwise cash flow and PV of cash flow N A B=A/(1.01^N) Month Cash flow PV of cashflow 0 $12,000 12000 1 $12,000 11881.18812 2 $12,000 11763.55259 3 $12,000 11647.08178 4 $12,000 11531.76413 5 $12,000 11417.58825 6 $0 0 (Beginning of month payments) TOTAL 70241.17487 Present Value of cost Leasing $          70,241 ADVICE: PURCHASE Present Value of Cost of purchasing is less than PV of cost of leasing

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