Question 5.EX.8: Evaluation of leasing versus borrowing to buy DDX plc is t...
Evaluation of leasing versus borrowing to buy
DDX plc is trying to decide whether to lease or to buy a machine with a useful life of six years. DDX could borrow £90,000 to buy the machine or lease it for annual lease rentals of £20,000 per year for six years, payable at the start of each year. If the machine is bought, maintenance costs of £1,000 per year will be incurred. These costs will not be incurred if the machine is leased. DDX pays tax at a rate of 30 per cent one year in arrears and can claim capital allowances on a 25 per cent reducing balance basis. The company’s before-tax cost of borrowing is 10 per cent. Should DDX lease or buy the machine?
As leasing is an alternative to borrowing, the relevant cash flows of the two alternatives can be compared using the after-tax cost of borrowing, i.e. 10 \times(1-0.30)=7 per cent.
The capital allowances are calculated as follows:
The tax benefits of borrowing to buy are calculated in Table 5.3. Notice that the maintenance costs give rise to tax relief, a point that is often overlooked.
We can now calculate the present costs of leasing and of borrowing to buy, as shown in Table 5.4. From this table we can see that the present cost of leasing (£75,276) is slightly higher than the present cost of borrowing (£73,063), and so on financial grounds we recommend that the machine should be bought. The present cost of borrowing to buy is included in the evaluation of the investment decision using the net present value method (Section 6.3).
Table 5.3 Tax relief computation for DDX plc if buying is used
\begin{array}{|c|c|c|c|c|c|}\hline \text { Year } & \begin{array}{c}\text { Capital } \\\text { allowances }(£)\end{array} & \begin{array}{c}\text { Operating } \\\text { costs }(£)\end{array} & \begin{array}{c}\text { Total } \\\text { deductions }(£)\end{array} & \begin{array}{c}30 \% \text { tax } \\\text { relief }(£)\end{array} & \begin{array}{c}\text { Taken } \\\text { in year }\end{array} \\\hline 1 & 22,500 & 1,000 & 23,500 & 7,050 & 2 \\2 & 16,875 & 1,000 & 17,875 & 5,363 & 3 \\3 & 12,656 & 1,000 & 13,656 & 4,097 & 4 \\4 & 9,492 & 1,000 & 10,492 & 3,148 & 5 \\5 & 7,119 & 1,000 & 8,119 & 2,436 & 6 \\6 & 21,358 & 1,000 & 22,358 & 6,707 & 7 \\\hline\end{array}
Table 5.4 The present costs of leasing and borrowing to buy for DDX plc
\begin{array}{|c|c|c|c|c|}\hline {\text { Present cost of leasing }} \\\hline \text { Years } & \text { Cash flow } & (£) & 7 \% \text { discount factors } & \text { Present value (£) } \\\hline 0-5 & \text { lease payments } & (20,000) & (4.100+1.000)=5.100 & (102,000) \\2-7 & \text { tax relief } & 6,000 & (5.389-0.935)=4.454 & \underline{26,724} \\& & & & \underline{(75,276)} \\\hline\end{array} \begin{array}{|c|c|c|c|c|c|r|}\hline {\text { Present cost of borrowing to buy }} \\\hline \text { Year } & \begin{array}{c}\text { Capital } \\(£)\end{array} & \begin{array}{c}\text { Operating } \\\text { costs }(£)\end{array} & \begin{array}{c}\text { Tax } \\\text { relief }(£)\end{array} & \begin{array}{c}\text { Net cash } \\\text { flow }(\Sigma)\end{array} & \begin{array}{c}7 \% \text { discount } \\\text { factors }\end{array} & \begin{array}{r}\text { Present } \\\text { value }(\Sigma)\end{array} \\\hline 0 & (90,000) & & & (90,000) & 1.000 & (90,000) \\1 & & (1,000) & & (1,000) & 0.935 & (935) \\2 & & (1,000) & 7,050 & 6,050 & 0.873 & 5,282 \\3 & & (1,000) & 5,363 & 4,363 & 0.816 & 3,560 \\4 & & (1,000) & 4,097 & 3,097 & 0.763 & 2,363 \\5 & & (1,000) & 3,148 & 2,148 & 0.713 & 1,532 \\6 & & (1,000) & 2,436 & 1,436 & 0.666 & 956 \\7 & & & 6,707 & 6,707 & 0.623 & \underline{4,179} \\& & & & & & (73,063) \\\hline\end{array}