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Dear friend
Please kindly explain to me 2 points in the Dec. 2009 Question 1
1. Why in the answer for cost of borrowing to buy: they do not calculate 8.6%
“”If ASOP Co bought the new technology, it would finance the purchase through a four-year loan paying interest at an
annual before-tax rate of 8·6% per year.””Evaluation of borrowing to buy
Licence Tax Net cash 6% discount Present
Year Capital fee benefits flow factors value
$ $ $ $ $
0 (1,000,000) (1,000,000) 1·000 (1,000,000)
1 (104,000) (104,000) 0·943 (98,072)
2 (108,160) 106,200 (1,960) 0·890 (1,744)
3 (112,486) 88,698 (23,788) 0·840 (19,982)
4 100,000 (116,986) 75,934 58,948 0·792 46,687
5 131,659 131,659 0·747 98,349
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(974,762)
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Present value of cost of borrowing to buy = $974,762
Workings
Licence fee
Year Capital allowance Tax benefits tax benefits Total
$ $ $ $
2 1,000,000 x 0·25 = 250,000 75,000 31,200 106,200
3 750,000 x 0·25 = 187,500 56,250 32,448 88,698
4 562,500 x 0·25 =140,625 42,188 33,746 75,934
5 421,875 – 100,000 = 321,875 96,563 35,096 131,659
ASOP Co should buy the new technology, since the present cost of borrowing to buy is lower than the present cost of leasing.2. The second question is why when they calculate the NPV they compare
the cost of saving and 1,135,557
Present cost of financing (974,762) (Borrowig to buy)
not compare the cost of saving and leasing????ominal terms net present value analysis
Year 1 2 3 4 5
$ $ $ $ $
Cost savings 365,400 479,250 637,450 564,000
Tax liabilities (109,620) (143,775) (191,235) (169,200)
–––––––– –––––––– ––––––––– ––––––––– –––––––––
Net cash flow 365,400 369,630 493,675 372,765 (169,200)
Discount at 11% 0·901 0·812 0·731 0·659 0·593
–––––––– –––––––– ––––––––– ––––––––– –––––––––
Present values 329,225 300,140 360,876 245,652 (100,336)
–––––––– –––––––– ––––––––– ––––––––– –––––––––
Present value of benefits 1,135,557
Present cost of financing (974,762)
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Net present value 160,795
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The investment in new technology is acceptable on financial grounds, as it has a positive net present value of $160,795.
Workings
Year 1 2 3 4
Operating cost saving ($/unit) 6·09 6·39 6·71 7·05
Production (units/year) 60,000 75,000 95,000 80,000
–––––––– –––––––– –––––––– ––––––––
Operating cost savings ($/year) 365,400 479,250 637,450 564,000
Tax liabilities at 30% ($/year) 109,620 143,775 191,235 169,200
(Examiner’s note: Including the financing cash flows in the NPV evaluation and discounting them by the WACC of 11% is- Topics: 0
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1. The company can claim 30% tax deduction on the 8.6% loan interest rate. Therefore, the after-tax borrowing cost is 6.02%, i.e. 8.6% x (1 – 30%), which is used to discount the financing cash flows.
2. ‘Buy’ has been proved to be a more favourable financing method at part (a). Therefore, ‘buy”s financing cost should be used to compare with the cost saving. On other words, forget the leasing option.
plz can anybody explain why dont we include cost values(license fee) in part b questions and why we discount rate 11%
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Part (b) is an extension of Part (a). The licence fee has been included in the $974,762 present cost of financing.
11% is given at the end of the question. It represent the cost of capital of the company. We should use different discount rates for the project (Part (b)) and the financing cash flows (Part (a)).
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how can they do it because they use diffence discount rate,6 % in part a and 11 % in part b for NPV? may be they wrong
I had the same problem with this question, I did it last night and found the answer a bit confusing. Just hoping that it won’t come up again this time.
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The answer is correct. Discount rate should reflect the level of risk. The risk of debt financing (reflected by the incremental cost of debt at part a) is different from the risk of the project (reflected by WACC at part b).
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