Reference no: EM132605144

Question - Southee Limited, a UK construction company, is planning to acquire new earthmoving equipment at a cost of £10 million, and is considering the following alternative sources of finance:

(i) A bank loan for the full cost of the equipment, repayable over four years in equal annual installments was incorporating interest at a rate of 5% per annum, the first installment to be paid one year from the date of taking out the loan.

(ii) A finance lease with a monthly lease rental of £223,000. The first rental is payable in advance, followed by further monthly rental payments for the next four years. The equipment would have no residual value at the end of the period of four years. The Company Secretary has a friend visiting from overseas, who has advised that it would be preferable to lease the equipment rather than buy it. The friend's argument is that leasing would avoid Southee's own capital being locked up, since it would be the lessor who would buy and own the equipment. Southee Limited is highly geared, and the friend has also suggested that leasing the equipment instead of borrowing to buy it would make Southee Limited's balance sheet look better. As an example of the convenience of leasing, the friend points to the rental car they have been using while visiting the UK.

Required -

a) Calculate the annual instalment that would be payable under the bank loan. Also calculate how much would represent the principal repayment, and how much would represent interest charges, in each of the four years and in total.

b) What is the before-tax rate of return to the lessor implied by the terms of the proposed lease agreement, and how does it compare with the rate of interest on the bank loan?

c) Discuss the soundness/relevance of the advice offered by the Company Secretary's friend.

d) Discuss the possible advantages to a company like Southee Limited of leasing the equipment rather than acquiring it with a bank loan.