Dear John,
Thanks for the great lectures and videos it is truly a great help and your explanation is phenomenal. I still have an ambiguity.
Example: suppose an asset costing 100,000 will be used for 6 years of project life that can be purchased by company money or borrowed money and it has no scrap value. If purchased from borrowed amount, principal must be repaid after 5 years.
Question: If asset is purchased by company money we have a cash outflow at t-0 of 100,000 and opportunity cost is taken care by DF (discount factor,Cost of Borrowing) but if it is purchased from borrowed money, DF will take care of interest payments but what about repayment of capital. we have a cash outflow of 100,000 at t-5 and no outflow at T-0 since it will be double counting.
If my approach is wrong and probably it is, how do we take account of the cash flow occurring at period 5 when we return the principal amount.

If out are borrowing money then the only reason you end up paying out more than the money borrowed is because you are paying interest on it.
Discounting the project at the cost of capital determines whether or not the inflows from the project cover the amount borrowed plus the interest on it.

For a fuller explanation do watch the Paper F2 lectures on interest and on investment appraisal, because this aspect is revision of F2.

Please why didn’t we apply the depreciation capital allowance to the lease, I thought that since we’re leasing the asset, we would have applied the 25% reducing balance then applied the tax rate or is this because the lease is a yearly one and not a long term lease?

Hello Sir John,
First of all I must say your explanations are so practically down to earth and not just learning rules without any understanding of what you are doing. I commend you for that.

What is bothering my mind however is that, I know we must used post tax discount rate in discounting during lease or buy decision. So if given pre tax rate of 20% and tax rate of 30% then the post tax rate will be 0.2*0.7=14%. Right? My questions are

1. Why do we have to use post tax rate. Cant we arrive at the same decision using the pre tax rate?

2. What is the reasoning behind that process of converting pre tax rate to post tax rate?

3. Is there any way to adjust the figure obtained after using pre tax rate in order to get the figure for using post tax rate?

Your quick reply will be very much appreciated. Thanks in advance.

We always use the post-tax rate (and using the pre-tax rate would not necessarily give the same decision).
(In most investment appraisal questions we have to calculate the WACC ourselves and then it is not just a matter of applying the tax rate, but this is dealt with in later chapters)

The reasoning is that interest is tax allowable and therefore (with tax at 30%) for every $10 they pay in interest, they save tax of $3, and therefore the net cost is only $7.

You can not adjust the figure obtained using the pre-tax rate to get the figure using the post tax rate (and it would be wasting time anyway).

Hi sir, great lecture. just wanna ask: if but will involve borrowing money and after tax interest @ 7% which means DF @ 7%. but does this DF only be for purchased option or both lease and purchase option? this part is the only part i dont get it, because question only state “buying” at second paragraph of example 3. Thanks in advance

They first get capital allowances in the year it was bought. So even though it was bought at the end of a year, you get it for that year and then for the next 4 years. So 5 years in total.

I am still a little confused about the dates and when will the first tax saving be. When you were discussing the Buy option you assumed that 2011 was going to be first year when we were to use the machine and we bought it on the 31st of Dec 2010.

Now I know that you assumed these dates just to give us the concept but from reading the question I don’t understand how can we say that 2010 is the current financial year on the last day of which the machine is bought and that 2011 will be the next year.

We are at the moment considering whether to buy or lease a new machine.
So we have not bought it yet and therefore the first year we will use it is next year.

The question says if we buy then it will be bought on the last day of the current year, and if we lease it then we will pay at the start of the year, so the first payment will be on the first day of next year.

The last day of this year and the first day of next year are both time 0 (we are never worried about one day when it comes to discounting), but – as I explain in the lecture – it will affect the timing of the tax flows.

good lecture sir,but i have on problem. if the lease payment was at the end of the year,in which year we should have claimed the benefit. please explain?

Yes (unless, of course, the same cost has to be paid if it is leased as well, in which case you can either bring it in for both or leave it out for both)

“If the machine is purchased,payment will be made in january of the first year of operation”
“if leased, annual lease rentals will be paid in january of each year of operation”
for me in both situation it is T0- 1.january??? could you explain???

I don’t know where you are quoting this from – it is not what the question in the lecture notes says (I assume that you have printed out the lecture notes?).

The first lease payment and the purchase of the machine are both effectively at time 0. It is the tax that is affected.

i have found in some answers of revision kit that while taking tax benefit of lease rentals in NPV calculation, examiner has claimed the benefit after one year and the other answer includes the same scenario with a claim after 2 years.
can u pls tell the reason and difference of both of these treatments?

One is whether the lease payments are at the start or the end of the years.
The second is whether tax is payable without delay or whether there is a one year delay.

I go through the rules regarding the date of payment of the tax in the lecture on DCF and taxation, although it is really only in lease buy questions that it becomes an important factor.

sarmad738 says

Dear John,

Thanks for the great lectures and videos it is truly a great help and your explanation is phenomenal. I still have an ambiguity.

Example: suppose an asset costing 100,000 will be used for 6 years of project life that can be purchased by company money or borrowed money and it has no scrap value. If purchased from borrowed amount, principal must be repaid after 5 years.

Question: If asset is purchased by company money we have a cash outflow at t-0 of 100,000 and opportunity cost is taken care by DF (discount factor,Cost of Borrowing) but if it is purchased from borrowed money, DF will take care of interest payments but what about repayment of capital. we have a cash outflow of 100,000 at t-5 and no outflow at T-0 since it will be double counting.

If my approach is wrong and probably it is, how do we take account of the cash flow occurring at period 5 when we return the principal amount.

John Moffat says

If out are borrowing money then the only reason you end up paying out more than the money borrowed is because you are paying interest on it.

Discounting the project at the cost of capital determines whether or not the inflows from the project cover the amount borrowed plus the interest on it.

For a fuller explanation do watch the Paper F2 lectures on interest and on investment appraisal, because this aspect is revision of F2.

Daniel says

Hi John,

Thanks for your lectures.

Please why didn’t we apply the depreciation capital allowance to the lease, I thought that since we’re leasing the asset, we would have applied the 25% reducing balance then applied the tax rate or is this because the lease is a yearly one and not a long term lease?

John Moffat says

If we lease an asset we do not get capital allowances.

Instead the lease payments are tax allowable.

Ernest says

Hello Sir John,

First of all I must say your explanations are so practically down to earth and not just learning rules without any understanding of what you are doing. I commend you for that.

What is bothering my mind however is that, I know we must used post tax discount rate in discounting during lease or buy decision. So if given pre tax rate of 20% and tax rate of 30% then the post tax rate will be 0.2*0.7=14%. Right? My questions are

1. Why do we have to use post tax rate. Cant we arrive at the same decision using the pre tax rate?

2. What is the reasoning behind that process of converting pre tax rate to post tax rate?

3. Is there any way to adjust the figure obtained after using pre tax rate in order to get the figure for using post tax rate?

Your quick reply will be very much appreciated. Thanks in advance.

John Moffat says

We always use the post-tax rate (and using the pre-tax rate would not necessarily give the same decision).

(In most investment appraisal questions we have to calculate the WACC ourselves and then it is not just a matter of applying the tax rate, but this is dealt with in later chapters)

The reasoning is that interest is tax allowable and therefore (with tax at 30%) for every $10 they pay in interest, they save tax of $3, and therefore the net cost is only $7.

You can not adjust the figure obtained using the pre-tax rate to get the figure using the post tax rate (and it would be wasting time anyway).

Ernest says

That was quick! Thank you very much for the quick reply. I am now ok with your explanation.

John Moffat says

Great 🙂

george says

Hi sir, great lecture. just wanna ask: if but will involve borrowing money and after tax interest @ 7% which means DF @ 7%. but does this DF only be for purchased option or both lease and purchase option? this part is the only part i dont get it, because question only state “buying” at second paragraph of example 3. Thanks in advance

george says

and my 2nd question it should be PV@7% or DF 7%? @23:11 of the tape

John Moffat says

We use the after tax interest on both the lease and the buy options in order to decide which is the better.

We calculate the present value at 7% by multiplying by the discount factors for 7%.

george says

thank you so much 🙂

John Moffat says

You are welcome 🙂

MP says

Hi,

I just want to check if my understanding is correct regarding the tax payments from what I have understood from the lectures.

If tax is paid one year in arrears

Purchase machine at start of the year – first tax payment in year 2

Lease payment at the end of the year – first tax payment in year 1

Also when you mentioned:

If tax is one year in arrears

– Payment at start of accounting year – tax effect is two years later

– Payment at end of accounting year – tax effect is one year later

I believe this rule applies to lease and purchase, is this correct?

Thanks

John Moffat says

Correct 🙂

hsohail says

Hello can you please explain again why did we calculate the Capital Allowance for five years, when the asset useful life is four years? why?

John Moffat says

They first get capital allowances in the year it was bought. So even though it was bought at the end of a year, you get it for that year and then for the next 4 years. So 5 years in total.

vida says

hi john,

i will like to know if there is a maintenance part of a question to the lease, can we make tax savings on the maintenance cost?

John Moffat says

Yes – maintenance costs would reduce the taxable profit and therefore result in a tax saving.

Arun says

Hi John,

I am still a little confused about the dates and when will the first tax saving be. When you were discussing the Buy option you assumed that 2011 was going to be first year when we were to use the machine and we bought it on the 31st of Dec 2010.

Now I know that you assumed these dates just to give us the concept but from reading the question I don’t understand how can we say that 2010 is the current financial year on the last day of which the machine is bought and that 2011 will be the next year.

I hope I was able to get my concern across.

Thanks.

John Moffat says

We are at the moment considering whether to buy or lease a new machine.

So we have not bought it yet and therefore the first year we will use it is next year.

The question says if we buy then it will be bought on the last day of the current year, and if we lease it then we will pay at the start of the year, so the first payment will be on the first day of next year.

The last day of this year and the first day of next year are both time 0 (we are never worried about one day when it comes to discounting), but – as I explain in the lecture – it will affect the timing of the tax flows.

tami005 says

good lecture sir,but i have on problem. if the lease payment was at the end of the year,in which year we should have claimed the benefit. please explain?

John Moffat says

I assume you mean the tax benefit. It would still be first at time 2.

If it is not clear why then you really should watch the lecture on investment appraisal with tax.

aanaa says

sir,why didn’t you calculate tax payable when DCF for buying option???

John Moffat says

What tax payable?

The tax effect of buying the machine is the tax saving from the capital allowances, and this I do calculate.

aanaa says

sir,what if there is any cost of buying the machine,eg: licence fee..

do we have to calculate the tax saving from the cost as well..??

John Moffat says

Yes (unless, of course, the same cost has to be paid if it is leased as well, in which case you can either bring it in for both or leave it out for both)

aanaa says

“If the machine is purchased,payment will be made in january of the first year of operation”

“if leased, annual lease rentals will be paid in january of each year of operation”

for me in both situation it is T0- 1.january??? could you explain???

John Moffat says

I don’t know where you are quoting this from – it is not what the question in the lecture notes says (I assume that you have printed out the lecture notes?).

The first lease payment and the purchase of the machine are both effectively at time 0. It is the tax that is affected.

zain says

i have found in some answers of revision kit that while taking tax benefit of lease rentals in NPV calculation, examiner has claimed the benefit after one year and the other answer includes the same scenario with a claim after 2 years.

can u pls tell the reason and difference of both of these treatments?

John Moffat says

It depends on two things.

One is whether the lease payments are at the start or the end of the years.

The second is whether tax is payable without delay or whether there is a one year delay.

I go through the rules regarding the date of payment of the tax in the lecture on DCF and taxation, although it is really only in lease buy questions that it becomes an important factor.

zain says

yes i got that but how can we differentiate between these two treatments? what hint will ques provide?? please answer

your’s grateful

John Moffat says

The question always tell you whether payments are in advance or arrears, and always tells you when the tax is payable!