Investment appraisal

This is all explained with an example in my free lectures on lease v buy.

The lectures are a complete free course for Paper FM and cover everything needed to be able to pass the exam well.

Have you actually watched my free lectures on this?

We calculate the present value of the lease flows (there is no initial investment if we lease), and separately calculate the present value of the buy flows (where there is an initial investment). Then we compare the two to see which is the cheapest.

In both cases we discount at the after-tax cost of borrowing, as again I explain in my free lectures.

I am sorry, I misunderstood your initial question (because I was reading it too quickly 🙁 )

Firstly, the project itself should always be appraised at the WACC.

If borrowing turns out to be cheaper than leasing, then no problem – you take the cash flows of the project in the normal way and discount at the WACC.

For the exam, if leasing turns out to be cheaper, then although again we would discount at the WACC for the purposes of deciding whether or not the project itself is worthwhile, take the project flows but use the purchase price (i.e. 600,000) as being the cost.
This can actually lead to other complications, but it is clear from the examiners answer that he is not bothered about that.

The first time that the examiner asked to choose between lease and buy for part (a) and then to appraise the project for part (b) he ended up having to allow a variety of answers for part (b) because of the potential problem. Since then he has avoided the problem and always kept the two parts separate and said for part (b) ‘assuming that they chose to buy’ appraise the project (regardless of whether leasing or buying was better for part (a) and there is little doubt that he will continue to do this if he asks a lease v buy question in the future.

In future please start a new thread when you are asking a different question 🙂

You will know from my free lectures that when there are 2 IRR’s then the graph showing the NPV against the rate of interest is a curve that crosses the axis twice at the two IRR’s when the NPV is zero.

This curve can either look like a ‘hill’ or be the other way round and look like a ‘valley’.

Here, since the undiscounted NPV is positive, then at 0% interest the NPV is positive. At 10% the NPV is zero, and the curve has fallen and will then give a negative NPV. It must then start increasing because it is zero NPV again at 25% and will then carry on increasing and so will then be positive for interest rates above 25%.