Purchase of Equipment Costing
Q1.Capital Constructions Ltd is considering the purchase of equipment costing $400,000, which it will fully finance with a fixed interest loan of 10% per annum, with the principal repaid at the end of 5 years. The new equipment will permit the company to reduce its to reduce its labour costs by $170,000 a year for 5 years, and the equipment may be depreciated for tax purposes by the straight-line method to zero over the 5 years. The company thinks that it can sell the equipment at the end of 5 years for $30,000.The equipment will need to be stored in a building, currently being rented out for $20,000 a year under a lease agreement with 5 yearly rental payments to run, the next one being due at the end of one year. Under the lease agreement, Capital Constructions Ltd can cancel the lease by paying the tenant (now) compensation equal to one year’s rental payment plus 10%, but this amount is not deductible for income tax purposes.This is not the first time that the company has considered this purchase. Twelve months ago, the company engaged Clever Consultants, at a fee of $23,000 paid in advance, to conduct a feasibility study on savings strategies and the company made the above recommendations. At the time, the company did not proceed with the recommended strategy, but is now reconsidering the proposal.The company further estimates that, starting in 2 years’ time, it will have to spend $10,000 every 2 years overhauling the equipment. It will also require additions to current assets of $27,000 at the beginning of the project, which will be fully recoverable at the end of the fifth year.Capital Constructions Ltd’s cost of capital is 14%. The tax rate is 30%. Tax is paid in the year in which earnings are received.REQUIRED:(a) Calculate the net present value, that is, the net benefit or net loss in present value terms of the proposed purchase and the resultant incremental cash flows.(b) Should the company purchase the equipment? State clearly why or why not.Q2. Two years ago, Lisa Brown borrowed $700,000 to recondition her travel cruiser. The loan from APC Bank required equal monthly repayments over 12 years, and carried.an interest rate of 8.4% per annum, compounded monthly.Today, after making the last monthly payment for the second year, the bank tells Lisa that the interest rate will be increased immediately to 10.2%, compounded monthly, in line with market rates. It also tells her that, with the rise in rates, she has two alternatives. She can increase her monthly repayment (so as to pay off the loan by the originally agreed date), or she can keep paying the same monthly repayment as now, but this will mean that she must extend the term of the loan.You are required to calculate:i) The new monthly repayment if Lisa accepts the first alternative.ii) The extra period added to the term of the loan if Lisa adopts the second alternative.