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Hello, part B of this question asks to choose the best project (all projects are divisible). As such I calculated the profitability index (NPV/Initial outlay), as shown below:
Option Initial outlay NPV NPV/Initial outlay
purchase 360,000 302,959 0.8415
finance 150,000 345,810 1.6387
operating 140,000 355,040 2.5360From he workings above , the purchase would be the best option. However the answer says that the finance lease should be chosen if capital rationing applies. I do not understand why. I also do not understand the layout of the answer in the BPP kit. Kindly explain please.
Your workings are treating the buying/leasing of the ‘major turbine machine’ as being divisible, which is not the case.
What the question means is that there is another investment project available, which is divisible, and requires 500,000 investment and gives NPV of 100,000.
If they finance the turbine from buying then they will need to pay out 360,000 immediately, which will mean 360,000 less available for this other project. So they will lose part of the NPV from the other project that they could have earned. The amount they will lose is 360,000/500,000 x 100,000.
The same will happen if they go for the operating lease, except that they will then only be losing 140,000 of the investment in this other project.
If they go for the finance lease then they will be able to do the other project in full (and so lose nothing) because the finance lease does not require an outlay immediately (the first payment is in one years time).
Hope that makes sense 🙂
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