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Hello Sir,
Please could you help me to understand the following:
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.
If ASOP Co bought the new technology, it would finance the purchase through a four-year loan paying
interest at an annual after-tax rate of 6%
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.
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 in the same year as the profits at an annual rate of 30%.1 – What is the net present value of the leasing cash flows if Asop Co lease the new technology?
The answer is $1,001,000
Thank you
If they lease then there will be lease payments of 380,000 a year from time 0 to time 3.
There will also be a tax saving of 30% x 380,000 = 114,000 a year from time 1 to time 4.Discounting at 6%, the PV of the payments is 1,395,740. The PV of the tax savings is 395,010.
Therefore the NPV of the leasing flows is 395,010 – 1,395,740 = $1,000,730 ( 1,001,000 to the nearest thousand).
I do explain all of this (with examples) in 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.
Thank you, I have rewatched it and it is much clearer now. Also I realised that your example is even more interesting because of the timing factor for tax. This now seems much easy than before in comparison!
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