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A company has an option to take three annual operating leases which require $375,000 to be paid on 1 January for each year of the project.
31st Dec year end and pays corporation tax 20 % one year after the relevant year end
post tax cost of capital is 11 %
The question asks you to work out the NPV of the cash flows associated with the operating leases.
I can’t get my head around the first bit of the workings which is:
$375,000 x 2.44 x 1.11
why is the 2.444 annuity rate multiplied by the cost of capital?
The annuity factor would assume that the first flow was in 1 years time.
Here the flows are in advance and so the first flow will be at time 0.
So our answer has used the 3 year annuity factor (as though it was from time 1 to 3), but because it is actually from time 0 to 2 they have effectively discounted by 1 year too many and to they are multiplying by 1.11 to account for it.
The alternative was (which I think is more obvious) is to say that the flows are from time 0 to time 2. The flow at time 0 has a discount factor of 1 (the PV is the same as the flow). For the flows from time 1 to time 2 use the 2 year annuity factor.
Multiplying therefore by 1 + 2 yr annuity factor will give the same answer (there will be rounding differences, but there are irrelevant in the exam)
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