Question 1 - lease or buy decision
Larine industries wants an airplane available for use by its corporate staff. The airline that the company wishes to acquire, a superjet, can be either purchased or leased from manufacturer.
Larine industries cost of capital is 20% and the tax rate is 30%.
The company has made the following evaluation of the two alternatives:
Purchase alternative
|
Purchase cost price
|
2 550 000
|
|
Annual cost of servicing and licence
|
27 000
|
|
Annual depreciation
|
50000
|
|
Repairs
|
|
|
first year
|
9000
|
|
Second year
|
9000
|
|
Third year
|
9000
|
|
Forth year
|
15000
|
|
Fifth year
|
30000
|
The superject would be solved after five years. Based on current values, the company would be able to sell it for one third of its original cost at the end of the five year period.
Lease alternative
If the superjet is leased, then the company would have to make an immediate deposit of 150 000 to cover any damage during use. The lease would run for five years, at the end of which time the deposit would be refunded.
The lease would require an annual rental payment of R600 000 at the end of each year. As part of the lease cost, the manufacture would provide all servicing and repairs.
At the of the five-year period, the plane would revert to the manufacturer, as owner.
Required:
1. Calculate the total after-tax cost of the present values of the cash flows associated with each alternative.
2. Which financial alternative would you recommend that the company accept? Why?
Question 2 ECONOMIC ORDER QUANTITY
The firm uses 223200 units of the item annually. It has order costs of R150 per order, and its carrying costs associated with this item are R20 per unit per year.
The firm plans to hold safety stock of the item equal to 4 days of usage, and it estimates that it takes 10 days to receive an order of the item once placed. Assume a 360 day year.
1. Calculate the firm's EOQ for the item of inventory
2. What is the firms total cost based upon the EOQ calculated above
3. How many units of safety should the firm hold?
4. What is the firm's re-order point for the item on inventory being evaluated?
QUESTION 3 GEARING
Tobi industries wishes to undertake a project that will cost R2 500 000. The project has already been evaluated and has a positive net present value.
The decision now facing management is how to finance the project. Three alternative financial packages are under consideration:
1. Issue 1250 000 new ordinary shares at 200 cents each; or
2. Issue R2 500 000 Debenture, doe in 2020, at a fixed rate of interest of 7%; or
3. Issue 1 000 000, 15%, R2.50 preference shares.
The project is expected to generate an extra R500 000 of earnings (before interest and tax) each year. The company pays tax at 30% and follows a policy of paying a constant ordinary divided per share.
The current abridged income statement and balance sheet are as follows:
|
Abridged income statement
|
Rand
|
|
Operating profit
|
2,200,000
|
|
Interest
|
600,000
|
|
Profit before tax
|
1,600,000
|
|
Tax
|
480,000
|
|
Profit after tax
|
1,120,000
|
|
Dividend
|
320,000
|
|
Retained income
|
800,000
|
|
|
|
|
Abridged balance sheet
|
7,000,000
|
|
Non-current assets
|
6,000,000
|
|
Current assets
|
13,000,000
|
|
|
|
|
Share capital and reserves
|
8,250,000
|
|
Ordinary share capital (50 cents)
|
1,000,000
|
|
Retained income
|
7,250,000
|
|
|
|
|
Non-current liabilities:16% Debenture, due in 2017
|
3,750,000
|
|
Current liabilities
|
1,000,000
|
|
|
13,000,000
|
Required:
1. Calculate the current earnings per share (EPS)
2. Calculate the current gearing (non-current debt/equity, using book value)
3. Calculate the revised EPS and gearing using ordinary share financing
4. Calculate the revised EPS and gearing using debenture financing
5. Calculate the revised EPS and gearing using preference share financing
6. Prepare a brief report, with supporting evidence, recommending which of these three financial sources the company should use. (Average gearing level of the industry is 90%).