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Hi,
Sorry for the long question,
December 2009 question,
ASOP Co is considering an investment in new technology that will reduce operating costs through increasing energy efficiency and decreasing pollution. The new technology will cost $1 million and have a four-year life, at the end of which it will have a scrap value of $100,000.
A licence fee of $104,000 is payable at the end of the first year. This licence fee will increase by 4% per year in each subsequent year.
The new technology is expected to reduce operating costs by $5·80 per unit in current price terms. This reduction in operating costs is before taking account of expected inflation of 5% per year.Forecast production volumes over the life of the new technology are expected to be as follows:
Year 1 2 3 4
Production (units per year) 60,000 75,000 95,000 80,000If ASOP Co bought the new technology, it would finance the purchase through a four-year loan paying interest at an annual before-tax rate of 8·6% per year.
Alternatively, ASOP Co could lease the new technology. The company would pay four annual lease rentals of $380,000 per year, payable in advance at the start of each year. The annual lease rentals include the cost of the licence fee.
If ASOP Co buys the new technology it can claim capital allowances on the investment on a 25% reducing balance basis. The company pays taxation one year in arrears at an annual rate of 30%. ASOP Co has an after-tax weighted average cost of capital of 11% per year.Required – Based on financing cash flows only, calculate and determine whether ASOP Co should lease or buy the new technology
Question
According to the question, the lease payment is paid in the beginning of the period and so the value of the machine will be recorded in Year 0 and the first tax benefit will arise in Year 2. (I understand this)
The buy option is confusing me. We are not told whether the machine is purchased at the beginning or at the end of the period ? (knowing it will help to indicate when will first tax benefit arises).How do i deal with the buy option ?
Kindly guide
Regards,
Please do not type out full exam questions – they are copyright of the ACCA and they get annoyed if we print them out here. I have all the past exam questions and so you just need to give the name and the exam for me to find any 🙂
As you have written, because the lease payments are paid at the start of the year, the first payment will be at the start of the first year which is time 0 (now!). Then obviously they can use the machine in the first year.
As far as buying is concerned, then again in order to be able to use the machine in the first year they need to buy it at the start of the first year, which again is time 0.
Have you watched 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.
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