Hi, welcome to a short video on Lease or Buy decisions, a particular type on investment
appraisal question.
My name is Chris Walsh.
We're going to use an exam question to sort out the idea for us and I've got a question
from December 2009 for F9.
So here it is in all its glory but we're only going to be looking at Part A and we'll look
at the requirement first.
Based on financing cash flows only calculate and determine whether ASOP Co should lease
or buy the new technology for eleven marks.
Now lease or buy decisions we're going to look at the relevant cash flows and there
are two options: lease or buy.
Under the buy option there are three possible cash flows although unusually in this question
we'll see there is a special guest appearance by a bit of an unusual cash flow this time.
The first cash flow under the buy option is the purchase price, the initial investment
and then you've bought the asset so it is your asset, you can claim the WDA's and you
get the tax saving on the WDA's and then finally at the end of the asset's life it is your
asset you can sell it and you get the scrap value, you get the disposal value or the residual
value.
Under the lease option there's only two cash flows: there the lease payments and there
normally in advance and then there's the tax saving on the lease payments so when you make
the lease payments that is an allowable expense for taxation purposes, it reduces your taxable
profit and reduces the tax that you pay so you get a tax saving.
A really important thing is the discount rate that you use and when you're doing a lease
or buy decision you use the post-tax cost of borrowing.
Now the post-tax cost of borrowing is equal to the pre-tax cost of borrowing multiplied
by 1 minus T where T is tax.
We only use this rate for lease or buy decisions, every other investment appraisal question
that we do we use the ordinary cost of capital but for lease or by decisions we use the post-tax
cost of borrowing.
Let's go to the body of the question.
ASOP Co is considering an investment in new technology that will reduce operating costs
through increasing energy efficiency and decreasing pollution.
The new technology will cost one million dollars, now that's the first of our cash flows under
the buy option so that's the initial investment, the purchase price and have a four year life
at the end of which it will have a scrap value of $100,000 so this is our second cash flow
under the buy option.
A licence fee of $104,000 is payable at the end of the first year, this licence will increase
by 4% per year in each subsequent year, now this is a very unusual cash flow for a lease
or buy decision as I said normally we have just the three for the buy option, we have
the initial investment, the tax save from the WDA's and the residual value just have
the two cash flows under the lease option the lease payments and the tax saving on the
lease payments but here we have an extra cash flow.
The new technology is expected to reduce operating costs by $5.80 in current price terms.
Now this is not relevant for Part A, it is not part of the lease or buy decision; it
comes into Part B where there was an ordinary investment appraisal, an ordinary NPV type
question.
The reason why it's not relevant is that here we're deciding whether to lease or buy equipment
and whether we lease it or buy it it's still the same equipment; it will still generate
the same cost savings so we can ignore those.
This reduction in operating costs is before taking account of expected inflation of 5%
per year, this also is not relevant, the operating costs are not relevant and therefore whether
they go up by 5% or not also not relevant.
Forecast production values over the life of the new technology are expected to be as follows:
in years one, two, three and four the production in units per year 60,000, 75,000, 95,000 and
80,000 units, again that is not relevant that happens whether we lease or buy the machine
and therefore we can ignore it in our decision.
If ASOP Co bought the new technology it would finance the purchase through a four year loan
paying interest at an annual before tax rate of 8.6% per year.
The 8.6% is a funny number, it's not a whole number, and the tables are only for whole
numbers.
The examiner has never made us use a funny number in the exam, what we're going to do
is we're going to adjust that figure, that figure is pre-tax and we're going to adjust
it by tax to find the post-tax cost of borrowing and it will turn into a beautiful number,
a whole number.
Alternatively ASOP Co could lease the new technology; the company would pay four annual
lease rentals of $380,000 per year, payable in advance at the start of each year.
The annual lease rentals include the cost of the license fee so under the lease option
we don't have to worry about the license fee, it's included within the $380,000 but we will
take it into account under the buy option.
If ASOP Co buys the new technology it can claim capital allowances on the investment
on a 25% reducing balance basis, that's the normal story.
He can change it from 25% if he wants and instead of having it as a reducing balance
he can make it straight line but the normal story is 25% reducing balance, that's the
story here.
The company pays tax one year in arrears and again he can change that if he wants, he can
have tax falling in the same year as the profit to which it relates but here the normal story
one year arrears and also the normal story tax is 30%.
ASOP Co has an after tax weighted average cost of capital of 11% per year, we're not
going to take that into account in part A, in part A we use the post-tax cost of borrowing
and that whack comes into part B for the ordinary NPV calculation.
Reading through the requirement again, required part Abased on financing cash flows only calculate
and determine whether ASOP Co should lease or buy the new technology for eleven marks.
We're going to start with the buy option, the buy option is easier and if you do the
buy option first you are more likely to get the lease option right as well and the very
first thing that we'll do is calculate the post-tax cost of borrowing which we will apply
to both options, both the lease option and the buy option.
So as you remember the post-tax cost of borrowing is equal to the pre-tax cost of borrowing
multiplied by 1 minus T.
The pre-tax cost of borrowing is 8.6% and tax is 30% so we're going to take the 8.6%
and multiply by 1 minus 0.3, the 0.3 being the 30% tax.
So 8.6% multiplied by 1 minus 0.3 is equal to 6.02% and we'll happily round that to 6%.
Right we're ready now for the buy option and the first thing we'll do there is calculate
the WDA's.
The technology costs a million but we're going to round it to the nearest 1000 so we'll write
it down as 1000.
In the first year we are allowed to claim 25% so 25% of 1000 is 250 and if we take that
away we end up with 750.
In year 2 we're allowed to claim 25% again but it a 25% reducing balance so it's 25%
of the 750.
25% of 750 is 187.5, well we'll round it to 188 and if we take that away we'll get 562.
In year three we'll claim 25%, 25% of 562 is 140.5 we'll round it to 141 and that will
leave us with 421.
Now year four is the final year, in the final year you do not do the 25% calculation, in
the final, year you get a balancing allowance or a balancing charge.
The final value, the disposal value, the residual value of the technology is 100 so we're now
going to calculate a balancing figure for year four, the 421 and the 100, the balancing
figure the difference between the two numbers is 321.
Now the 250, the 188, the 141 and the 321 that's what we claim and they will bring a
tax saving.
We're going to multiply those numbers by 30% and that will give us the cash effect the
number that we put into our NPV, our investment appraisal question it will give us the tax
saving.
So multiplying by 30% we get 75, 56, 42 and 96, the last piece of the puzzle is the timing
and we claim the 250 in year one and it brings a tax saving of 75 in year two because there
is a one year delay so the timing for the year one cash flow, a one year delay brings
it to year two and then carrying on with that that will be years three, four and five.
So now we're ready to put the numbers into the investment appraisal, I'll have years
0,1,2,3,4 and 5 and I'll have cash flows in thousands and I'm going to start off with
the licence fee.
Now the licence fee is 104 in year one, we’re told within the question and then it goes
up by 4% per year so we'll do a working for this and if you look at working one we see
that's its 104 in year one and then it goes up by 4%, pretty much brings it up to 108
and then going up by 4% again brings it up to 112 and then going up by 4% again brings
it up to 117.
So if we plug those into our investment appraisal into the NPV we get the 104, the 108, the
112, the 117 and there all in brackets these are negative cash-flows these are expenses,
these are costs.
Now something that people find difficult is that this is a cost, a negative cash flow
and it brings a tax saving, if we make a profit we pay tax, if we make a negative profit we
pay negative tax.
The idea is that here we have an expense and it will reduce the tax profit and will reduce
the tax that we pay so on these cash-flows we're going to multiply by 30% and we're going
to delay it by one year because tax is paid one year in arrears.
So the first figure is 104, if we multiply that by 30% we get 31.2 I'll round it to 31
and that will appear in year two, a one year delay and then multiplying the 108 and the
112 and the 117 by 30% we get 32, 34 and 35 and again those will all be delayed so it
will be years two, three, four and five.
I'll bring forward the tax saving of the WDA's that we've already calculated so the 75, the
56, the 42 and the 96 and now there are only two more cash-flows: the initial investment
which is 1000 in year zero and the residual value which is 100 in year four, a positive
number.
That's it those are all the cash-flows and in fact it's two more than we usually get
because we don't normally have the licence fee and we don't normally have the tax associated
with the licence fee.
We’re going to net these figures off to get the net cash-flow and now we're going
to discount them.
If you remember the discount factor is at 6% and the 6% discount factors are 1.943,
0.890, 0.840, 0.792 and 0.747 and if we multiply those numbers together the discount factors
by the net cash flows we'll get the PV and then the NPV.
The NPV is - $975,000.
Now your first instinct then would be that this is a bad option, it's got a negative
NPV but when we do lease or buy decisions the NPV's are nearly always negative, for
a start the machine that we're talking about might not generate any revenue, it might not
generate any contribution, it might just have costs and what we want to do is get the machine
in the cheapest possible way, the way that has the least costs.
So it might be an air conditioning system, well the air conditioning system will not
generate any revenue, it will not generate any contribution, it will just generate costs
and we want it as cheap as possible but in this case the equipment brings a saving, but
that saving happens whether we lease it or whether we buy it and therefore we can ignore
it so we only look at costs and indeed if you look at the requirement for part A it
says 'only looking at the financing costs' then what we want to do is minimise those
costs so we will have two negative NPV's and we'll choose the one that's slightly smaller,
the one that involves the least cost.
So we've done the buy decision and we're now onto the lease option, we're going to have
four columns, we're going to have year, cash flow, discount factor and PV.
There are only two cash flows: one is the lease payment and those are $380,000 every
year, a cost and then there's the tax saving; now we're going to multiply the 380 by 30%
and that will give us a tax saving of 114.
The trickiest bit of the lease option is deciding which years, now it's a four year life that
we're looking at and the lease payments are made in advance, there will be four payments.
If they weren't made in advance then it would simply be years one, two, three and four but
because there made in advance the years will be nought, one, two and three.
The tax is just that little bit harder now if we go back to the buy decision and look
at the timing of the tax cash flows we can see that they were in years two, three, four
and five and they will be the same under the lease option as well so it will be years two,
three, four and five, it will be years two to five.
The next thing then is the discount factors, we're going to use annuity factors and years
nought to three what we're probably going to do the way you'll probably like to do it
is look at the year three figure.
Now if you look up year three in the annuity tables you find 2.673 but you know that that
means years one to three and we want nought to free so we also have to add on year zero
and the discount factor for year zero is 1, that gives us a total of 3.673 and if we multiplied
that by the 380 then we get 1,396 negative.
Using a similar idea then we're probably going to focus on year five for the tax saving.
If you look up year five in the annuity tables then you find 4.212 but again you know that
that means years one to five.
We don’t want one to five we want two to five so we need to strip out year one, we're
going to take out 0.943 this gives us a discount factor of 3.269 and gives us a PV of 373 positive
and netting the two figures off we get 1023 negative and we're going to compare that negative
NPV with the other negative NPV which was negative 975 and we prefer the 975.
The buy option is cheaper; it's cheaper by $48,000.
So that’s it, that’s lease or buy decisions and in the is particular question people did
well at parts (b) (c) and (d)but the examiner said they did very badly on part (a)on the
lease or buy decision and that's the story for lease or buy decisions.
Thank you.