- 20 Marks
FM – Nov 2018 – L3 – Q2 – Financing Decisions and Capital Markets
Evaluate financing options for machine acquisition using present value and compare traditional financing with Islamic finance.
Question
Tamilore Limited (TL) is an agro-based firm, specializing in yam and rice production in Benue State of Nigeria. One of the harvesters is due to be replaced on November 30, 2018, the last day of TL’s current financial year. An investment appraisal exercise has recently been completed which confirmed that it is financially beneficial to replace the machine at this point. TL is now considering how best to finance the acquisition of the harvester to be replaced. TL is already highly geared.
A government development agency has offered the following two alternative methods of financing the machine:
Alternative 1
A loan of N49,200,000 at 6% interest rate to buy the machine on November 30, 2018. If this option is selected, the machine will be depreciated on a straight-line basis over its estimated useful life of 5 years.
Alternative 2
Enter into a finance lease. This will involve payment of annual rental of N12 million with the first payment due on November 30, 2019. The lease payments will be for the entire estimated useful life of the machine, which is 5 years, after which ownership will pass to TL without further payment.
Other information
(i) Whether leased or purchased outright, maintenance would remain the responsibility of TL and would be N450,000 payable annually in advance.
(ii) TL is liable to tax at a rate of 25%, payable annually at the end of the year in which the tax charge or tax saving arises.
(iii) TL is able to claim capital allowances on the full capital cost of the machine in equal installments over the first four years of the machine.
(iv) Assume that TL has sufficient taxable profits to benefit from any savings arising therefrom.
(v) All workings in N’000.
Required:
a. Show that the implied interest rate in the lease agreement is 7%. (3 Marks)
b. Advise, using present value method, whether Tamilore Limited should borrow to buy the machine or lease it. (12 Marks)
c. Instead of lease financing, one director has suggested an equivalent Islamic finance.
i. Explain briefly the principles of Islamic finance. (2 Marks)
ii. Explain three main advantages of Islamic finance. (3 Marks)
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