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Dear Sir,
I’ve watched your lecture on lease or buy decisions, however I’m not sure how to proceed with one of section C questions – there is information not only about cost of machine and it’s scrap value, but also about additional working capital required throughout the life of the machine – should we take it into account when calculating cost of leasing or buying the machine?
Besides that, there is also information that to purchase the machine we need to use the bank loan with an interest charge of 9% (I assume that this is before tax, and when taking the tax off it gives us 6.3% – so it’s strange to discount at that rate) and there is also an information that the after tax cos of capital the company uses to appraise the investments is 10% – so in this case this 9% is only to make some confusion?
Please be kind to advise on that one.
Thank you!To properly answer you I need to see the whole question.
If it is a past exam question, then tell me which exam; alternatively, if it is in the current edition of the BPP Revision Kit then tell me the number of the question.
Please see the question below:
Pluto Co is considering the purchase of a new plant worth $350,000 which it is anticipating will create operational savings. Annual cash inflows of $96,250 are expected. Plant will have life of 5 years and scrap value of $52,500 at the end of its useful life.
Operating the new plant will require an additional investment in working capital of $17,500 throughout the life of the machine.
Pluto Co can either purchase the plant using a bank loan with an interest charge of 9% or lease it for a lease charge of $70,000 payable annually in advance.
The corporate tax rate is 30% payable one year in arrears and capital allowances are available on a 25% reducing balance basis.
Pluto Co uses an after-tax cost of capital of 10% to appraise investments and has a target before-tax ARR of 15% where ARR is calculated on average investment basis.
Required:
(a) Calculate both the ARR and NPV of the proposed purchase and determine whether or not the plant should be acquired.
(10 marks)
(b) Assuming it is beneficial to acquire the plant calculate whether it should be purchased or leased.
(6 marks)
(c)Discuss strengths and weaknesses of ARR as a project appraisal technique.
(4 marks)
(Total: 20 marks)I am puzzled as to why you are attempting a question for which you do not have an answer. You should be using a Revision Kit from one of the ACCA approved publishers – they have answers and explanations!
To decide whether or not to invest in the project, we discount at the WACC because we need to take all costs of finance into account.
To decide which is cheaper, we use the after-tax cost of borrowing. which would indeed be 6.3% assuming that you have copied all of the question correctly. It would be very unusual indeed in the exam to have to discount at 6.3% (although you are expected to know how to do it, from Paper F2).
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