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Can we discount net cashflows with two different discount factors in Lease & Buy questions. Or it has to be just one WACC where we discount both Leasing & Buying?
There is a question ASOP Co (Dec 2009) where we are given 11% after-tax WACC but we are also told that to buy new technology it is financed by a loan purchase paying interest at before-tax cost of capital of 8.6%.
Do we have to discount Lease with 11% WACC and discount Buying with 6% after-tax WACC?
Or we can simply discount both of them with just 11% after-tax WACC?
When we are deciding whether to lease or to buy for part (a) of the question then we must discount both sets of flows at the same interest rate otherwise it would not be possible to compare them, and we discount at the after tax cost of borrowing.
I explain this in my free lectures on lease and buy (and explain why this is the case)!!!
For part (b) of the question we are not deciding whether to lease or to buy. The question says that they are buying and so it becomes a normal project appraisal question and we discount at the WACC.
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1) For Part (a) of the question relating to Lease & Buy as you said that it is not possible to discount Leasing or Buying cases with two different after-tax cost of borrowing rather we always discount them at one after-tax cost of borrowing otherwise it is not worth comparing!
To get after-tax cost of borrowing we need to do : 8.6 x (1 – 0.3) = 6.02 (round-off to 6%)
2) But the problem I’m having is that can we use the after-tax WACC of 11% which is given in the question rather than using 6%?
In short, either we are going to discount both (lease n buy cases) on 6% after-tax cost of capital or 11% which totally depends on me which one to use! (I get full marks by using either?)
No you cannot use 11% when making the decision as to whether to lease or to buy. As I replied before, for this decision we discount at the cost of borrowing of 6% (just as in the examiners answer).
You will not get full marks by using either. You would not lose all the marks if you discounted at 11% – you would still get the marks for the cash flows – but you would not get full marks.
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