Final answer:
To decide whether the flour mill should lease or purchase equipment, we need to compare the present value of leasing costs (including tax benefits) with the present value of buying costs (considering loan interest, tax deductions, maintenance costs, and salvage value), relative to the mill's weighted average cost of capital and marginal tax rate.
Step-by-step explanation:
The decision on whether a small scale flour mill should lease the equipment or purchase it can be made by comparing the total costs of leasing versus buying, considering the tax implications, maintenance costs, cost of capital, and opportunity cost of using the funds elsewhere.
For leasing, the total lease payments over 10 years would be Rs 2,80,000 (Rs 28,000 per year multiplied by 10 years). Since lease payments are tax-deductible, the after-tax cost of leasing would need to be calculated. With a 40% marginal tax rate, the tax savings from the lease payments would be Rs 1,12,000 (40% of Rs 2,80,000), reducing the net cost of leasing to Rs 1,68,000. Furthermore, there are no maintenance costs associated with leasing, as these would typically be covered by the lessor.
For purchasing, the equipment cost of Rs 2 lakh can be financed at a pretax rate of 10% from SBI. The interest expense over the 10-year loan period must be considered, as well as the annual maintenance costs of Rs 1,000 and the salvage value of Rs 20,000 at the end. The interest expense is tax-deductible, and we must also consider the cost of capital, which is 12%. The analysis involves calculating the present value of all these cash flows to make an accurate comparison.
The decision is not straightforward and requires detailed financial analysis, which includes calculating the present value of lease payments and weighing that against the present value of buying and maintaining the equipment. This analysis should also factor in the opportunity costs of alternative investments that could be made with the capital required to purchase the equipment.