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  1. Hello Sir,
    I鈥檓 a bit confused with the taxation allowance timing -in the example here the tax allowance is recognized at t1, while in the examples presented in DCF lectures -taxation, the first capital allowance was at t2. Please advise, why in this lecture we assume the first tax allowance to be in t1 not as in DCF-taxation lecture – in t2? Thank you in advance.

  2. Hi John! I have doubt regarding after tax interest cost. It’s clearly mentioned in the question that “Buying” a machine shall involve borrowing money at an after tax rate of 7% (or a before tax rate of 10%).
    But nothing is mentioned as such for source of capital while leasing. So basically it should have been raised internally and for that we get tax benefits only for the expenses we made (i.e the amount of lease p.a. $35,000).
    The point I want to make is that discounting factor in case of leasing part should be at the rate of internal cost of capital that certainly is not necessarily 7%.
    And if we assume that the cost of capital for debt and own sources is same, then shouldn’t the lease part of question be discounted at 10% as it involves no savings on interest costs.
    Please correct me if an wrong.
    Regards.

    • Sorry, but you are wrong.

      Buying does not actually involve a cash flow at time 0 (you borrow the money and immediately pay it out on the machine). The actual cash flows are the repayments of the borrowing. However you will know from other lectures (and from Paper F2) that the PV of the repayments will always equal the amount borrowed.

      Consider this – suppose you borrowed 10,000 at 10% and bought the machine, and repaid the 10,000 (together with interest) in equal instalments over 5 years. The repayments would be 10,000/3.791 – 2,638 per year. (3.791 is the 5 year annuity factor at 10%).
      Suppose instead you leased the machine and had to pay 2,500 per year for 5 years.
      Which would you prefer? Obviously you would prefer to lease.

      However, it is not so clear cut in a full exam question (as in the example in the lecture) because of the tax and because of the timing of the flows. So instead, in order to find out which is cheaper, we compare the PV of the two alternatives, but because we are simply trying to determine which is cheaper – leasing or buying – we discount at the cost of buying.

  5. Dear Sir,

    Firstly thank you so much for your lecture.
    Please, I need a clarification regarding the tax saving of the lease payment.

    I understood from F7 that only the depreciation of the right to use asset and the finance cost are expenses not the lease payment … therefore I was expected the tax saving to be calculated based on the depreciation and the finance costs only not on the lease payment..

    Could you please kindly explain why the tax saving is calculated based on the lease payment.

    Kind regards,

  6. Hi John,
    In the previous lecture you mentioned that in a case where the capital allowance exceeds 25% during disposal the excess should be treated as an outflow in order to stay within the capital allowance allocation. I see in this question the total capital allowance was 27000 while it shouldn鈥檛 have exceeded the 25000. Am I looking at it the wrong way or is it what is it. Please shed more light on this.
    Thanks.

    • I did not say that at all!!!

      The balancing charge in the final year is the difference between the sale proceeds of 10,000 and the tax written down value of 31,641.

      The total of all of the allowances is 90,000 (the cost less the disposal proceeds), and the total tax saved as a result is 30% x 90,000.

      I do suggest that you watch my lectures on investment appraisal with tax, because these are standard tax rules.

    • Nonsense 馃檪

      The figures are in brackets because they are costs!!

      A cost of 69,960 is lower than a cost of 93,607 and therefore is is better to buy than to lease.

      Whether you bother putting brackets round them or not is completely irrelevant – this is not a maths exam. The examiner is testing that you understand what is happening 馃檪

  12. Good day Sir,
    i still can not understand why we use time 0 for the end of year the machine was bought.
    shouldnt we have used time 1 since the question says that the machinwas bought at the end of the current financial year

    • Time 0 is a point in time, time 1 is a point in time 1 year later, and so on.

      The machine is bought at time 0.
      The capital allowances are calculated at the end of the accounting period, which in this example is also time 0.
      The questions says that tax is payable one year after the end of the financial year, and so the tax saving will occur one year later, which is time 1.

      Have you watched the earlier lectures on relevant cash flows for DCF where I explain the tax rules?

      • Dear Sir,

        May I ask you one more question. In the text book example,
        (a) The company could purchase the machine for cash, using bank loan facilities on which the current rate of interest is 13% before tax.
        (b) The company could lease the machine under an agreement which would entail payment of $4,800 at the end of each year for the next five years.
        Tax payment is not mention in the example and assumed that one year in arrears.
        For Lease aspect,
        1) Rental is time 0 or time 1 as said that at the end of each year?
        2) Tax saving 30% also time 1 or time 2?
        Thanks.

        May.

      • In future you must ask questions like this in the Ask the Tutor Forum and not as a comment on a lecture.

        On the wording as you have typed it, the first lease payment will be at time 1 and if the tax is a year in arrears then the first tax saving will be at time 2.

    • Dear Sir,

      Sorry to ask here because that is related question.
      If so, example 3 and my question, what is difference?
      1) In the question, Rental is at the end of each year question,
      the first lease payment will be at time 1.
      2) In the question,bought on the last day of current financial years, it is at
      time 0.

      May.

      • In example 3, the question says that lease payments are payable at the start of each year – so the first payment is immediately i.e. time 0.

        When buying, the cost will also be payable immediately i.e. time 0. (We are not bothered about a difference of 1 day when we come to discounting)

  15. Dear John,

    I know this question has been asked before, but I’m afraid I have to ask again.

    Why did you not include a line for tax on operating cashflows like you did in Chapter 8, question 3?

    I understood that we had to pay tax on investment but also if given capital allowance then we have a line for the tax saving also.

    However in the above example it is a little confusing as to why you did not including whether to buy the machine.

    I thought we would have to pay tax at 30% on the cost of acquiring the machine as we did in Chapter 8 questions 3 & 4?

    In the questions 3 & 4 we buy a machine and calculate tax payable

    In question from lecture above we buy a machine but don’t calculate tax payable??

    I understand it is different from tax and inflation questions but cannot identify why it is treated differently.

    Sorry I just really need clarification

    • We assume that the operating flows (apart from the lease payment) will be the same whether we buy the machine or lease it, so they do not need to be considered.

      All we consider are the lease payments and their tax effect; and for buying we consider the cost and scrap and the tax savings on the capital allowances (and they are calculated in exactly the same way as always).

  17. Thank you for the good lectures Mr. Moffat.
    Can you clarify please on the buy option:
    1. Why is the initial cost at T0 when the question states that the asset will be purchased at the end of the current year, isn’t the current year, year one such that initial cost is at T1 and
    2. why does the balancing allowance occur at T5 and not T4. I thought the balancing allowance is calculated at the end of the life of the asset which is the same time as when the asset is disposed of.

    thank you once again for the great job.

    • We normally let the date of the initial cost be the starting point i.e. time 0. The only relevance of it being at the end of the current year is for the timing of the capital allowance flows.

      The allowance is indeed calculated at time 4, but the tax effect is one year later because the question says that tax is payable one year in arrears.

  18. In a question it is stated that the lease rental Is payable in advance . it means we pay lease rental in year0. but when we are calculating relief or saving on lease rental , the relief amount is in year 2 . why is it so? can u please explain? thanks

    • One more thing Sir , I past paper question named Leaminger .Co the question states that for buy or lease of asset use cost of capital of 10% and there is no cost of borrowing is given n we are told to use cost of borrowing for lease or buy questions. What should I do here ?

    • There is no such thing as year 0. Time 0 is the start of the first year, the tax is calculated at the end of the first year which is time 1. With a one year delay in tax the tax effect is one year later at time 2.
      This is all explained in the lecture and in the earlier lectures on investment appraisal with tax.

  19. Dear John,
    Thanks for the great lectures and videos it is truly a great help and your explanation is phenomenal. I still have an ambiguity.
    Example: suppose an asset costing 100,000 will be used for 6 years of project life that can be purchased by company money or borrowed money and it has no scrap value. If purchased from borrowed amount, principal must be repaid after 5 years.
    Question: If asset is purchased by company money we have a cash outflow at t-0 of 100,000 and opportunity cost is taken care by DF (discount factor,Cost of Borrowing) but if it is purchased from borrowed money, DF will take care of interest payments but what about repayment of capital. we have a cash outflow of 100,000 at t-5 and no outflow at T-0 since it will be double counting.
    If my approach is wrong and probably it is, how do we take account of the cash flow occurring at period 5 when we return the principal amount.

    • If out are borrowing money then the only reason you end up paying out more than the money borrowed is because you are paying interest on it.
      Discounting the project at the cost of capital determines whether or not the inflows from the project cover the amount borrowed plus the interest on it.

      For a fuller explanation do watch the Paper F2 lectures on interest and on investment appraisal, because this aspect is revision of F2.

  20. Hi John,

    Thanks for your lectures.

    Please why didn’t we apply the depreciation capital allowance to the lease, I thought that since we’re leasing the asset, we would have applied the 25% reducing balance then applied the tax rate or is this because the lease is a yearly one and not a long term lease?

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