Leasing Vs Buying

Model answer F3: buying or leasing assets
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Chartered Institute of Management Accountants 1. 2. 3. 4. 5. 6. 7. Home Innovation E-magazines Velocity Velocity 2012 Velocity February 2012 Model answer F3: buying or leasing assets

February 2012
Before attempting this question, please read this Financial Management magazine article by William Parrott, published in the December 2011-January 2012 issue. A construction company has conducted an investment appraisal on a four year project and has decided to proceed with the project. The project involves the acquisition of plant and machinery that could be purchased for USD290,000. The plant and machinery is expected to have a negligible residual value at the end of the project. Alternatively the asset could be leased using a finance lease for USD85,000 per year, payable in arrears. Under the finance lease, the lessee is responsible for all maintenance costs of the plant and machinery during the lease term. After the lease period ownership of the plant and equipment would pass to the construction company. The
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The company is subject to tax at 22%. The tax is payable as the liability arises. Tax depreciation allowances are available to the purchaser of business assets at 40% per year on a reducing balance basis. The company can borrow at a rate of 9% per annum. Question: Determine whether it will be cheaper for the company to lease or to buy the asset. Solution: Post tax cost of debt: Post tax cost = 9% x (1 0.22) = 7% NPV of cost to buy: Working one tax savings on tax depreciation allowances USD000 Initial cost Year 1: 40% Tax written down valueTax saving at 22%Timing 290.0 (116.0) 25.5 End of year 1 174.0 Year 2: 40% (69.6) 15.3 End of year 2 104.4 Year 3: 40% (41.8) 9.2 End of year 3 62.6 Year 4: balancing allowance(62.6) 13.8 End of year 4 Residual value 0.0 Working two Cash flow table for asset purchase USD000 Initial cost Tax savings Start End of year 1End of year 2 End of year 3End of year 4 (290.0) 25.5 15.3 9.2 13.8 ____ ____ ____ ____ ____ Net cash flows (290.0)25.5 15.3 9.2 13.8 7% discount factors1 0.935 0.873 0.816 0.763 Present values (290.0)23.8 13.4 7.5 10.5 Net present value (234.8) NPV of cost to lease: Working three NPV using the sum of digits approach There are four lease payments of USD85,000 so the total to be paid is USD340,000. As the asset cost is USD290,000 the interest implied in the lease must be USD50,000. (USD340,000 USD290,000) This implied interest must then be spread across the number of years for which interest is to be paid. As the last lease payment will be paid at the end of year four, the interest must be spread over four years.
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The interest to be allowed each year can then be calculated as follows: Year one: USD50,000 x 4/10 = USD20,000 Year two: USD50,000 x 3/10 = USD15,000 Year three: USD50,000 x 2/10 = USD10,000 Year four: USD50,000 x 1/10 = USD5000 The sum of the digits calculation has told us to work in tenths and in the first year we take 4/10 as we want to spread the interest over four years. The numerator then declines each year. Tax relief calculation USD000 Year 1Year 2Year 3 Year 4 Allowable interest 20.0 15.0 10.0 5.0 Accounting depreciation (290/4years)72.5 72.5 72.5 72.5 Total tax allowable costs 92.5 87.5 82.5 77.5 Tax savings at 22% 20.4 19.2 18.2 17.0 Receivable at end of year 1 2 3 4 NPV of cost calculation USD000 StartEnd of year 1End of year 2End of year 3End of year 4 Lease charge 0 (85.0) (85.0) (85.0) (85.0) Tax savings b/f 20.4 19.2 18.2 17.0 ____ ____ ____ ____ ____ Net cash flows 0 (64.6) (65.8) (66.8) (68.0) 7% discount factors1 0.935 0.873 0.816 0.763 Present values 0 (60.4) (57.4) (54.5) (51.9) Net present value (224.2) NPV of cost to lease: Working four NPV using the actuarial approach The first step is to estimate the interest implied in the lease. To do this we need to find the discount rate which makes the future lease charges to be paid equivalent to the cost of the plant and equipment. The cost of the equipment is USD290,000 which is to be repaid by four equal annual instalments of USD85,000. The relevant four year cumulative present value factor is USD290,000/USD85,000 = 3.412 From the tables the four year cumulative present value factor at 6% is 3.465 and at 7% it is 3.387. Hence the implied interest cost is between 6% and 7%. By interpolation the interest cost can be calculated to be: 6% + (3.465 3.412)/(3.465 3.387) x (7% - 6%) = 6.7% approx. In the exam you may to choose to simply use the nearest % cost which would be 7% in this instance. While it is better to use the more accurate interest cost it is more important that you complete the question in the time you have and show that you know the technique.
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Opening balanceInterest at 6.7%RepaymentClosing balance USD000 USD000 USD000 USD000 Year 1290.0 19.4 (85.0) 224.4 Year 2224.4 15.0 (85.0) 154.4 Year 3154.4 10.3 (85.0) 79.7 Year 479.7 5.3 (85.0) 0 In this instance the final closing balance has neatly arrived at nil. In reality a small figure may remain here due to rounding errors. You should not worry about this. Tax relief calculation USD000 Year 1Year 2Year 3 Year 4 Allowable interest 19.4 15.0 10.3 5.3 Accounting depreciation (290/4years)72.5 72.5 72.5 72.5 Total tax allowable costs 91.9 87.5 82.8 77.8 Tax savings at 22% 20.2 19.3 18.2 17.1 Receivable at end of year 1 2 3 4 NPV of cost calculation USD000 StartEnd of year 1End of year 2End of year 3End of year 4 Lease charge 0 (85.0) (85.0) (85.0) (85.0) Tax savings b/f 20.2 19.3 18.2 17.1 ____ ____ ____ ____ ____ Net cash flows 0 (64.8) (65.7) (66.8) (67.9) 7% discount factors1 0.935 0.873 0.816 0.763 Present values 0 (60.6) (57.4) (54.5) (51.8) Net present value (224.3) Conclusion: Hence in this circumstance it can be seen that the leasing option seems to be the cheapest. Links F2 external reporting: IFRS and US GAAP convergence are we there yet? Strategic level Contact us What did you think of this article? Please email velocity@cimaglobal.com with editorial comments, questions and suggestions. Please email advertising@cimaglobal.com for advertising questions and rates. Velocity is the global e-magazine for CIMA students. It is sent to approximately 100,000 students once every two months.
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Leasing Vs Buying

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Model answer F3: buying or leasing assets

Produced with a Trial Version of PDF Annotator - www.PDFAnnotator.com

Model answer F3: buying or leasing assets

Model answer F3: buying or leasing assets

Model answer F3: buying or leasing assets

Model answer F3: buying or leasing assets

Model answer F3: buying or leasing assets

Email: cima.contact@cimaglobal.com Or find your local CIMA office

Find out more

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