Evaluation of leasing versus borrowing to buy DDX plc is trying to decide whether to

Question

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?

Accepted Answer

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. [latex]10 imes(1-0.30)=7[/latex] per cent.
The capital allowances are calculated as follows:

[latex]\begin{array}{lrr} ext { Year } & & { £} \1 & \qquad 90,000 imes 0.25= & \qquad22,500 \2 & 22,500 imes 0.75= & \qquad16,875 \3 & 16,875 imes 0.75= & \qquad 12,656 \4 & 12,656 imes 0.75= & \qquad 9,492 \5 & 9,492 imes 0.75= & \qquad 7,119 \6 & ext { (by difference) } & \underline{21,358} \& & \underline{90,000}\end{array}[/latex]

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).

Question 5.EX.8: Evaluation of leasing versus borrowing to buy DDX plc is t...

Related Answered Questions

Evaluation of equity finance versus debt finance PXP plc is a listed company that has ...

Verified Answer:

Explain the difference between a conversion premium and a rights premium. ...

Verified Answer:

Explain the difference between a finance lease and an operating lease, and discuss the importance of the distinction for corporate finance. ...

Verified Answer:

A company has in issue some 9 per cent bonds which are redeemable at nominal value of £100 in three years’ time. Investors require a yield of 10 per cent. What will be the current ex-interest market value of each bond? What would be the current ex-interest market value if the bonds had been ...

Verified Answer:

Explain what is meant by the following terms that refer to bonds: (a) restrictive covenant; (b) refinancing; (c) redemption window. ...

Verified Answer:

Explain the nature of the following items and state the circumstances under which their issue would be beneficial to (i) lenders and (ii) borrowers: (a) deep discount bonds; (b) zero coupon bonds; (c) warrants; (d) convertible bonds. ...

Verified Answer:

A company has in issue a 10 per cent bond, redeemable at the option of the company between one and five years from now. What factors will be considered by the company in reaching a decision on when to redeem the bond? ...

Verified Answer:

What is the gearing effect of warrants? ...

Verified Answer:

Outline the advantages and disadvantages to a company of issuing convertible bonds. ...

Verified Answer: