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Socks Ltd manufactures socks and legwarmers and wants to expand its product line. The management of the company has indicated that a new machine is required to manufacture a new line of brightly coloured socks. To purchase the machine, it has negotiated financing with a favourable before tax cost of 3% interest per annum with equal annual instalments. Alternatively, the company can enter into a direct financial lease with the manufacturer of the machine, which means that the manufacturer will offer the machine and maintenance on it for the useful life of the machine at a cost of R130 000 per year, paid at the start of each year for three years.
The machine costs R400 000 and it is expected that it will require maintenance of R70 000 per year, if bought. It is also expected that the machine can be sold for R200 000 at the end of its useful life of three years. The machine can be depreciated by way of the straight-line method over a period of three years.
A tax rate of 28% is applicable.
The company has a before tax cost of debt of 11%.
Required:
Determine the net advantage of leasing and advise the company on the option they should take based on your findings.
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