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Hello Sir,
(1) If, while deciding whether to lease or buy, we are given two discount rates such as WACC = 11% and after tax Cost of borrowing = 6%, then why do we use after tax cost of borrowing as discount factor while calculating the PV of Leases part. Why not WACC?
(2) And the reason we use after tax cost of borrowing as discount factor while calculating the PV of Buying the machine is because it would involve borrowing the money from bank in order to finance the purchase? Am I right?
Thanks
It is because we are trying to decide which is the cheaper form of financing, and not whether or not the machine is worth having, which is a separate problem.
We know the cost of borrowing and so discounting both sets of flows at this rate enables us to check whether leasing is cheaper or more expensive than borrowing.
When we have decided how it is best financed, then we discount the project flows at the WACC as usual to decide whether it is worth doing at all.
If they purchase it, they will be borrowing money, although it is extremely unlikely that the money will be borrowed from the bank! More likely (as usual) it would be borrowed from long-term debt finance.
Have you watched my free lectures on lease or buy? The lectures are a complete free course for Paper FM and cover everything needed to be able to pass the exam well.
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