Reference no: EM132996979

Question - Freeline Limited, a South African-based brick manufacturing company, intends to expand its output capacity in order to meet the expected increase in demand from the construction industry. The company plan is to acquire a new machine from China. They have the option to either lease or purchase the new machinery. The machinery has a cost of R3,150,000. LEASE: The company can lease the machinery under a three-year lease. They have to make a payment of R1,075,000 at the end of each year. Freeline Limited has the option to buy the machinery at the end of the lease for R700,000 and the financial manager intends on exercising this option. All maintenance and insurance costs are borne by the lessor. BUY: Alternatively, the company could finance the R3,150,000 cost of the machinery through its retained earnings, payable upfront. Freeline Limited will also pay an additional R108,000 per year for insurance costs while the current running costs (water and electricity) for similar machines are R102,000 per annum. Maintenance costs are expected to be R69,000 per annum. Insurance is expected to increase by 10% per annum starting from year two. Due to improvements in the water supply and the use of renewable means of energy in the factory, running costs are expected to decrease at a rate of 15% per annum starting from year two. Maintenance costs are expected to increase by 20% per annum starting from year two as any replacement parts would have to be sourced from China. Assume that the current corporate tax rate is 28% and the after tax cost of debt is 16%. You are required to determine the after-tax cash flows and the net present value of the cash outflows under each alternative. Briefly indicate which alternative should be recommended.