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I’m cunfused that wether financing decision is taken first or investing decision?
As I’m told by my lecturer that first we decide wether to invest or not. then, the problem is we take the cashflows related to buy decision in investment apraisal means that we had already decided to purchase the asset on the other hand we still have to caompare lease and buying cash flows. And if NPV comes negative we stop furthur working on it but if we had performed lease vs buy decision and got the lease agreement benificial, now if we replace the cashflows related to purchasing the asset with leasing cashflows and NPV is converted to positive,here we had lost the opportunity of exercising a profitable project.Your lecturer is correct – we first decide whether or not it is worth investing, and then we decide which is the cheapest way of financing. (certainly, that is the case for the exam)
The reasoning is that effectively leasing is just like borrowing – it is just that instead of having to make fixed interest payments each year (as we do when we borrow) we have to make fixed lease payments in each. So as far as shareholders are concerned the effect is similar and the fixed payments make things more risky for shareholders, and therefore they want a higher return.
We assume (and it is a big assumption) that in the long term the WACC will stay contact (because in the long term we will keep the level of gearing the same.
So…..we appraise the project at the WACC (to cover the long term cost of capital), but in the short term we want to borrow in the cheapest way.In fact, there are arguments about this – different academics want to do things different ways.
The examiner does realise this, and so on the few occasions that he has asked lease and buy he has told you what to do (or has given full marks for doing things differently).
For the exam, best is to do what your lecturer has said – appraise the project at the WACC (the investment decision) and then choose how to finance (the financing decision).
Unless of course the question specifically tells you to do different, which is not likely.
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