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Hawker Co is about to replace its existing delivery vehicle with a new design of vehicle that offers greater fuel economy. It estimates that replacing the existing vehicle will save running costs of $2,000 per year There are two financing options
Option 1
The vehicle could be purchased for $34,000 using a bank loan with an after-tax cost of borrowing of 4% per year. The vehicle would have a useful me of four years and would have a residual value of $14.000 at the end of that period. Straight-line tax allowable depreciation is available on the vehicle. The vehicle would be subject to a government CO2 emissions tax of $600 at 1 end of each year of operation Emissions tax expenses are corporation tax deductible.
Option 2
The vehicle could be leased for a period of four years for a payment of $6,000 per year, payable at the start of each year The estor will pay the CD; emissions tax Lease payments are a corporation tax deductible expense Hawker Co’s after tax weighted average cost of capital is 8% It pays corporation tax at a rate of 20% one year in arrears
Discount factor taken in NPV of both leasing and borrowing loan to buy asset is 4%. Can you tell me why don’t 8% is taken?
Because we are not appraising the investment but are just deciding which is the cheaper option (and we are not calculating the NPV – we are calculating the PV of each set of flows).
To do this we discount both sets of flows at the cost of borrowing.I do explain this in my free lectures on lease and 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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