Question

TK Travel (Pty) Ltd is considering the purchase of a tanker for R400 000 cash or lease the tanker. This will be a 5-year lease/contract and it will require a down payment of R100 000 and further payments of R100 000 per year at the end of each year. If the tanker is owned, the service and maintenance charges will be R15000 pa, (per annum) but if the tanker is leased this charge is carried by the lessor. The salvage value of the tanker in 5 years' time is expected to be R40 000. The company uses the straight-line method of depreciation. The prevailing tax rate is 27% and the after-tax cost of debt is 10%. Required: Calculate the cost of owning against the cost of leasing and advise on the best option. Justify your answer.

Answer 1

To advise TK Travel (Pty) Ltd on whether to buy or lease a tanker, one must consider the total costs over five years, including initial costs, annual payments, depreciation, maintenance, salvage value, and tax effects, and compare the net present value of owning versus leasing.

Step-by-step explanation:

Cost Analysis: Buy vs. Lease Tanker

To determine whether TK Travel (Pty) Ltd should purchase or lease a tanker, one must compare the cost of owning and the cost of leasing, taking into account initial outlays, ongoing expenses, depreciation, salvage value, and tax implications. The purchase option has an upfront cost of R400,000. Annual service and maintenance costs for ownership are R15,000. Depreciation is calculated using the straight-line method over five years, resulting in an annual depreciation expense of (R400,000 - R40,000) / 5 years = R72,000. The salvage value is expected to be R40,000 at the end of the period. Tax savings from depreciation and service charges should be considered. When leasing, a down payment of R100,000 is made, followed by annual payments of R100,000. The lessor covers service charges. The cost of ownership and leasing will be further adjusted by the after-tax cost of debt, which stands at 10%.

It is crucial to note that the total costs should be compared on an after-tax basis to reflect the true economic cost to the company. The decision will depend on the net present value of each option, taking the after-tax cost of capital as the discount rate.

The lease option may offer advantages, such as lower initial and annual cash outflows and absence of maintenance costs, which could make it financially more attractive for the company. However, the ownership option might be cost-effective in the long run, especially when considering the salvage value, despite higher annual depreciation and maintenance costs.

Leasing a vehicle, as a more general observation, usually requires a smaller down payment and has lower monthly payments compared to outright purchases, making it initially appear more affordable. But in long-term scenarios, owning the asset might prove to be more economical despite higher upfront costs, particularly as leasing may come with extra charges for surpassing mileage limits, and the company does not retain asset ownership at the end of the lease term.