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Hello Mr Moffat,
I found a question whose solution was contrary to my understanding.
It was a Lease or Buy decision and tax payment was delayed by one year.
A problem:
As for the ‘Buy’ decision of course, they regarded Tax savings on Tax Allowable Depreciation as occuring from year one, while on ‘Lease’ side, tax saving on rent was well taken from year two.
Isn’t it that the two taxes should be timed the same way?May you help me sir on this.
It depends on the date of the purchase and the date of the first lease payment.
Without seeing the question you are referring to, I would assume that the lease payment is at the start of each year. The tax will be calculated at the end of the year (so 1 year later) and then the tax effect will be one year later still (so 2 years later i.e. time 2).
I would assume (again without seeing the question) that the purchase cost when buying was paid at the end of the current year, in which case the capital allowance would be calculated immediately and the tax effect will be one year later (i.e. time 1).
This is all explained with an example in my free lectures on lease and buy.
The real question is here sir Moffat.
Cubic Ltd has decided to acquire an asset worth $2m.
Options available.(a) Acquire the asset by taking a bank loan @ 15% p.a. repayable in five yearly instalments of $0.4m each plus interest.
(b) Lease the asset at yearly rentals of $0.648m for five years starting from the end of year 1.
In both cases, the instalment is payable at the end of the year. The rate of capital allowance applicable to the company is 15% using reducing balance method. The corporate tax rate is 35% and tax is paid one year after the end of the accounting year in which the transaction occurs.
Suggest which option would be more financially viable.
I have two issues here.
i) Tax saving on Rent starts at year 2 as for Lease which I agree
but
Tax saving on Write Down Allowances starts at year 1 as for Buy.ii) Wording of the question makes me believe that the first rent pay should be at year 2, thereby shifting tax relief to year 3 but rent is seen from year 1.
Would you shed some some light sir.
1. With regard to the writing down allowance when buying, it depends whether the machine was bought at the end of an accounting period (in which case the first tax saving will be at time 1), or whether it was bought at the start of an accounting period (in which case the first tax saving will be at time 2).
2. The question says that the first rent is at the end of the first year. The end of the first year is 12 months from ‘now’ (time 0) and is therefore time 1.
(Time 1, time 2, etc are not years – they are points in time that are 12 months apart.
Time 0 is ‘now’ – the start of the first year.
Time 1 is 1 year from now – the end of the first year/start of the second year
Time 2 is 2 years from now – the end of the second year/start of the third year.Please do watch my lectures on investment appraisal.
(I replied to your other post on lease and buy, and then accidentally deleted the thread. What I had typed four years ago was a typing mistake – what is in the lecture notes and my lectures ic correct 🙂 )
Thanks but I still have some concerns.
As for (ii), I understand the timing. My sole concern is that I considered the Lease itself to be delayed by a year rather than Rent payment. That’s why I thought that Rent would be paid 1 yr later at year 2.
As for (i), it looks like I am still not clear on the timing issues.
Buy At start of period, use year 2?
Buy at end of period, use year 1?
Is tax saving affected by tax delays?Thanks in advance and I will watch the lecture.
Also, the question does not expressly say when the machine was bought so I presume it at start of year one.
This would make tax saving from year 2 according to you but they used year .
I doubt their solution.They will need to start using the machine immediately, whether they buy it or lease it.
So the lease starts immediately – all that is relevant is when they make the payments. Either at the start of each year (as is usually the case in exam questions) or at the end of each year (as is the case in this question).
Tax is calculated at the end of the accounting period. The effect of the tax occurs one year later (assuming as here that there is a 1 year delay in tax).
I cannot really comment on what they have assumed in this question without seeing the whole question. It is always clear what to do in exam questions (we always assume the asset is purchased at the start of an accounting period unless the question says differently.
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