LEASE OR BUY DECISION
6. Leaminger plc has decided it must replace its major turbine machine on
31 December 2002. The machine is essential to the operations of the company. The
company is, however, considering whether to purchase the machine outright or to
use lease financing.
Purchasing the machine outright
The machine is expected to cost $360,000 if it is purchased outright, payable on
31 December 2002. After four years the company expects new technology to make
the machine redundant and it will be sold on 31 December 2006 generating
proceeds of $20,000. Capital allowances for tax purposes are available on the cost
of the machine at the rate of 25% per annum reducing balance. A full year’s
allowance is given in the year of acquisition but no writing down allowance is
available in the year of disposal. The difference between the proceeds and the tax
written down value in the year of disposal is allowable or chargeable for tax as
appropriate.
Leasing
The company has approached its bank with a view to arranging a lease to finance
the machine acquisition. The bank has offered two options with respect to leasing
which are as follows:
Finance lease
Operating lease
Contract length
4 years
1 year
Annual rental
$135,000
$140,000
First rent payable 31 December 2003
31 December 2002
General
For both the purchasing and the finance lease option, maintenance costs of $15,000
per year are payable at the end of each year. All lease rentals (for both finance and
operating options) can be assumed to be allowable for tax purposes in full in the
year of payment. Assume that tax is payable one year after the end of the
accounting year in which the transaction occurs. For the operating lease only,
contracts are renewable annually at the discretion of either party.
Leaminger plc has adequate taxable profits to relieve all its costs. The rate of
corporation tax can be assumed to be 30%. The company’s accounting year-end is
31 December. The company’s annual after tax cost of capital is 10%.
Calculate the net present value at 31 December 2002 of purchasing the
machine outright and for both leasing options and recommend the optimal
method.
ANSWER
6. Leaminger Plc
Purchase outright
Initial outlay
2002
2003
2004
2005
2006
2007
$
$
$
$
$
$
(360,000)
Maintenance
20,000
(15,000) (15,000) (15,000) (15,000)
Tax benefit @ 0.3
4,500
4,500
4,500
4,500
CA tax benefit
0
27,000
20,250
15,188
11,391
28,172
Net cash flows
(360,000)
12,000
9,750
4,688
20,891
32,672
1.000
0.909
0.826
0.751
0.683
0.621
(360,000)
10,908
8,054
3,521
14,269
20,289
10% discount
DCFs
NPV: -$360,000 + $10,908 + $8,054 + $3,521 + $14,269 + $20,289 = -$302,959
2002
2003
2004
2005
2006
2007
$
$
$
$
$
$
Tax WDV
360,000
270,000
202,500
151875
113,906
CA at 25%
90,000
67,500
50,625
37,969
93,906*
27,000
20,250
15,188
11,391
CA benefit @ 30%
28,172
*Balancing allowance: $113,906 - $20,000 = $93,906
Finance lease
PV
$
Annual rental: $135,000 x 3.170
(427,950)
Maintenance cost: $15,000 x 3.170
(47,550)
Rent tax benefit: $135,000 x 0.3 = $40,500 x [3.791 – 0.909 = 2.882]
116,721
Maintenance cost tax benefit: $4,500 x 2.882
12,969
NPV
(345,810)
Operating lease
PV
$
Annual rental: $140,000 x [2.487 + 1 = 3.487)
Tax relief of rental cost: $140,000 x 0.3 = $42,000 x 3.170
NPV
(488,180)
133,140
(355,040)
The outright purchase is the recommended as it is the least costly method with
the lowest PV of cost.