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  1. Hello Sir John,
    First of all I must say your explanations are so practically down to earth and not just learning rules without any understanding of what you are doing. I commend you for that.

    What is bothering my mind however is that, I know we must used post tax discount rate in discounting during lease or buy decision. So if given pre tax rate of 20% and tax rate of 30% then the post tax rate will be 0.2*0.7=14%. Right? My questions are

    1. Why do we have to use post tax rate. Cant we arrive at the same decision using the pre tax rate?

    2. What is the reasoning behind that process of converting pre tax rate to post tax rate?

    3. Is there any way to adjust the figure obtained after using pre tax rate in order to get the figure for using post tax rate?

    Your quick reply will be very much appreciated. Thanks in advance.

    • We always use the post-tax rate (and using the pre-tax rate would not necessarily give the same decision).
      (In most investment appraisal questions we have to calculate the WACC ourselves and then it is not just a matter of applying the tax rate, but this is dealt with in later chapters)

      The reasoning is that interest is tax allowable and therefore (with tax at 30%) for every $10 they pay in interest, they save tax of $3, and therefore the net cost is only $7.

      You can not adjust the figure obtained using the pre-tax rate to get the figure using the post tax rate (and it would be wasting time anyway).

  2. Hi sir, great lecture. just wanna ask: if but will involve borrowing money and after tax interest @ 7% which means DF @ 7%. but does this DF only be for purchased option or both lease and purchase option? this part is the only part i dont get it, because question only state “buying” at second paragraph of example 3. Thanks in advance

  3. Hi,

    I just want to check if my understanding is correct regarding the tax payments from what I have understood from the lectures.

    If tax is paid one year in arrears

    Purchase machine at start of the year – first tax payment in year 2
    Lease payment at the end of the year – first tax payment in year 1

    Also when you mentioned:

    If tax is one year in arrears

    – Payment at start of accounting year – tax effect is two years later
    – Payment at end of accounting year – tax effect is one year later

    I believe this rule applies to lease and purchase, is this correct?

    Thanks

      • But Teacher, Tax pay one year inarrears, so in total will be only 4 years likes previous examples with operating cashflows. I till have a ambiguity for this. please help me to clear with thanks

      • The fact that tax is payable one year in arrears has nothing to do with how many capital allowance calculations there are.

        As I explained in my previous reply, the first capital allowance calculation is done in the year in which the machine was bought (even though it is bought on the last day of the year) and then for each of the years in which it was used (i.e. another 4 years) – so there are 5 computations in total.

        I assume that you have been watching the lectures on order and have therefore already watched the lecture on investment appraisal with tax.

  6. Hi John,

    I am still a little confused about the dates and when will the first tax saving be. When you were discussing the Buy option you assumed that 2011 was going to be first year when we were to use the machine and we bought it on the 31st of Dec 2010.

    Now I know that you assumed these dates just to give us the concept but from reading the question I don’t understand how can we say that 2010 is the current financial year on the last day of which the machine is bought and that 2011 will be the next year.

    I hope I was able to get my concern across.

    Thanks.

    • We are at the moment considering whether to buy or lease a new machine.
      So we have not bought it yet and therefore the first year we will use it is next year.

      The question says if we buy then it will be bought on the last day of the current year, and if we lease it then we will pay at the start of the year, so the first payment will be on the first day of next year.

      The last day of this year and the first day of next year are both time 0 (we are never worried about one day when it comes to discounting), but – as I explain in the lecture – it will affect the timing of the tax flows.

  9. “If the machine is purchased,payment will be made in january of the first year of operation”
    “if leased, annual lease rentals will be paid in january of each year of operation”
    for me in both situation it is T0- 1.january??? could you explain???

    • I don’t know where you are quoting this from – it is not what the question in the lecture notes says (I assume that you have printed out the lecture notes?).

      The first lease payment and the purchase of the machine are both effectively at time 0. It is the tax that is affected.

  10. i have found in some answers of revision kit that while taking tax benefit of lease rentals in NPV calculation, examiner has claimed the benefit after one year and the other answer includes the same scenario with a claim after 2 years.
    can u pls tell the reason and difference of both of these treatments?

    • It depends on two things.

      One is whether the lease payments are at the start or the end of the years.
      The second is whether tax is payable without delay or whether there is a one year delay.

      I go through the rules regarding the date of payment of the tax in the lecture on DCF and taxation, although it is really only in lease buy questions that it becomes an important factor.

  11. Lease or buy is basically a finance decision, why is it treated under investment appraisal??? Knowing fully well that its not a project. Can smbody help??

    Regards

    • Why on earth should we care which heading it is put under? You are not tested on headings in the exam!

      We have put it with investment decisions because that is where the examiner puts in his syllabus. Presumably because we use the same discounting techniques and because we are effectively investing in an asset in order to undertake a project whichever way we choose to finance it.

  14. Hi..I have a doubt.. In one of the examples pertaining to the comparison of lease vs buy,it was written that”purchase of machinery would be financed through a four year loan paying interest at an annual rate of 8.6%” why didn’t we take this and its tax implication into consideration??

  15. Hello Sir,
    I have a confusion with the statement in the question
    “Buying it will involve borrowing money at an after tax interest cost of 7% p.a”
    It only says buying it so why do we use the interest rate of 7% for leasing, or is it that we assume that the money is always borrowed?

  17. Hello Jon,

    Example 3 purchase VS lease,when you calculate the CA tax savings for the machine, you applied 5 years savings but the machine only last for 4 years, why? Because it was bought at last day of accounting year?

    • Yes. Because it was bought on the last day of the year, you would get CA’s for that year. Then you use it for 4 years and you get CA’s for those 4 years as well.

      (It is something that really only happens in the exam in a lease/buy question. Normally in other questions we assume the machine is bought on the first day of a year and so it if lasts 4 years there are 4 CA calculations)

  18. I got few confusions John:

    1-
    The corporation tax was as a tax payable, but in lease you didn’t assume it as subtraction like rather than ($10500), you simply indicated as +$10500.

    2-
    In ch#8 ex3 and onwards, we continued to assume that taxation 1 year in arreas and put on the profit’s figure year later, like $1000 profit in year2 and 25% tax = $250 in year 3. BUT why we moved to another forward year, althought you told us that its rule…ahh but why this?

    3-
    The purchase was made at year0 and hence 0,1,2,3years become 4years, with the fact that we purchased on year 0, regardless of its date( dec 31), but why it happened as year forward?

    I know its all about dates problems but I think I need your bit help, although major part of help is being conducted through your lectures 馃檪

    Many Thanks

    • 1 The tax is not payable. We are making lease payments, these will be allowable for tax, so it will reduce our existing tax liability – we will save tax.

      2 We usually assume that operating flows are at the ends of year. So it will affect the profit immediately, and the tax effect will be one year later.
      The lease payments are made at the start of the year, so it will affect the profit calculated at the end of the year (i.e. one year later), and the tax effect will be one year after that.

      (The cash flows are points in time – they are not whole years. Time 0 is now, time 1 is one year from now, time 2 is 2 years from now, etc..)

      3 We usually assume that machine are bought at the start of a year. In which case, then capital allowances are calculated at the end of the year (i.e. time 1) and the tax effect is one year later (time 2).
      This question says that the machine is bought on the last day of the current year. So (from Paper F6) the first capital allowances will be calculated immediately (cos we are at the end of the year) and the tax effect will be one year later – i.e. time 1.

      It is only with lease and buy that you have these tax timing problems (because otherwise it would be too easy 馃檪 )
      To be honest I will be surprised if it is asked this time because it was asked last time.

      • Thanks for the help. Its clear now. “To be honest I will be surprised if it is asked this time because it was…”: my habit is I never see guess before exams as it ruins my psychology and I feel that I am bad at other topics. Its also recommended by you and examiner. Why we guess for some topics if you teach us everything here 馃檪

        Many Thanks

      • ah one more thing as you explained, so we assume generally preculded from leasing that the cash outflows at year start( costs ) and it cash inflows at year end ( profits), hence we put scrap value that likely. But now here we are assumed at 31st Dec, so this way it also extends the scrap figure to year forward.

        Many Thanks

  19. Hi John, firstly, thanks for your great lectures! You make it very easy to understand the concepts. I need one clarification on the tax rule you mentioned at the end of this lecture: “Payment at the end of accounting year – tax effect is 1 yr later.” Is the “end of accounting year” referred to here is the “current” accounting year? Is it the day before time 0? Also, when the term “current” is mentioned in the exam, is it usually the period before time 0, like for example, the inflation of costs referred to in example 4, chapter 8?

    Thanks much!
    Musa

  20. Hello John, I’m a bit confused with this example, you assume the year end is December, so 1.1.2011 is beginning of the year, 31.12.2011 is the year end, corporation tax is payable one year after the year end, so should be 31.12.2012. If 2011 is year 0, then 2012 should be year 1, the tax savings should be the end of year -31.12.2012, why do you say it is in year 2 2013 which is 2 years after the year end of initial payment?

    • Time 0, time 1 etc are not years, but points in time.

      The first payment is on 1.1.2011, time 0. The tax is calculated at the end of the year and payable one year later I.e 31.12.2012.

      From 1.1.2011 to 31.12.2012 is two years (we are not bothered about one day) and therefore is time 2 because it needs discounting for two years interest.

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