Reference no: EM13333331
ABC Wines Company is considering the acquisition of a new irrigation system for its extensive vineyards. The system could either be bought outright for £10 million or via a finance lease requiring three annual payments in advance of £3.7 million. The leasing company is not the supplier or manufacturer of the equipment.
The new system is expected to give the following pre-tax net cash savings over the existing system in use:
Year Pre-tax net cash savings
1 £6 million
2 £5 million
3 £3 million
The system would require replacement in three years' time and have no residual value. The outright purchase would be financed by a loan with an interest rate of 8%.
Assume that corporation tax is charged at 25% and is payable one year in arrears. Writing down allowances is available on the depreciation of the equipment. The company uses the reducing balance method for depreciation at 25%. Lease payments are allowable for tax in full.
The company has no gearing at present and a cost of capital of 13%.
Complete the following:
1. Evaluate whether ABC Wines should go ahead with the installation of the new irrigation system and whether they should use the purchase or the lease option. (Tip: You should use NPV to perform the analysis; writing down allowances should be taken into consideration.)
2. Explain the primary ways in which finance leases differ from operating leases.
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: Evaluate whether ABC Wines should go ahead with the installation of the new irrigation system and whether they should use the purchase or the lease option and explain the primary ways in which finance leases differ from operating leases.
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