Reference no: EM132468915

(a) A firm has decided to acquire a new machine to neutralise the toxic waste produced by its refining plant.

The machine would cost £6.4 million and would have an economic life of five years.

• Writing down allowances (WDAs) of 25% per annum, on a reducing balance basis, are available for the investment. Taxation of 30% is payable on operating cash flows, one year in arrears.

• The firm intends to finance the new plant by means of a five-year fixed interest loan, at a pre-tax cost of 11.4% pa, principal repayable in five years' time.

• As an alternative, a leasing company has proposed a finance lease over five years at £1.42 million per annum, payable in advance.

• The scrap value of the machine under each financing alternative will be zero.

Requirement

Question (i) Evaluate the two options for acquiring the machine and advise the company regarding the best alternative.

Question (ii) Discuss THREE factors which should be considered in a lease verses buy decision.

(b) A machine has an initial cost of £3,500. The annual maintenance costs of the machine are forecast to be £900 in the first year, £1,000 in the second year and £1,200 in the third year of ownership.

• The residual value of the machine is expected to be £2,100 after two years, and £1,600 after three years.

• The cost of capital of the company is 11% per year.

Requirement

Question (i) Calculate the optimal replacement cycle for the machine.

Question (ii) Identify TWO limitations of replacement cost analysis.