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sir do we use after tax cost of capital only when we finance is borrowed from debt? Do we assume for lease vs buy we finance through debt and not equity . what is there was a mixture of both does wacc would still be called after tax cost of capital.
We use the after-tax WACC to appraise projects regardless of how they are financed (and there are full free lectures on the calculation and use of the cost of capital).
When deciding whether to lease or to buy we are not appraising the project, we are simply deciding which is the cheapest way of financing, which is why we discount the lease flows at the after-tax cost of debt.
Sir isn’t financing is obtaining a source of fund from bank or from investors. how is leasing financing?
This is really confusing me sir, with other sources of finance we were receiving cash but leasing we are not if we are the lesse if so then how is a source of finance. or financing can meaning other things?
Financing from debt will involve receiving cash but then immediately paying out the cash to buy the machine. The new cash flows that result are then the repayment of the borrowing together with interest.
When leasing, they still end up with the machine, but the cash flows that result are the the lease payments (instead of the repayments of borrowing and interest).
If they want a new machine then it has to be financed from somewhere – either they then have the repayments of the borrowing or they have the lease payments. The end result is similar (except that the resulting payments may be cheaper for one way of financing than for the other, which is what we are checking in lease and buy calculations).
okay sir so what would be the reason that we use after tax cost of debt in lease vs buy but cost of capital in replacement descion? and also financing does not always mean raising money?
We use the after tax cost of debt in lease and buy simply to see whether leasing is cheaper or more expensive than buying.
We use the WACC when appraising whether or not new projects are worthwhile in order to see whether or not the returns from the project cover the overall weighted average cost of capital (and there is more explanation of this in the later lectures on the WACC).
Financing a machine is looking at how we manage to acquire the machine. Usually it involves borrowing money because we will usually be buying the machine. Leasing is different, but is still a way of being able to have the machine (and as I wrote before still involves paying out cash in the future years in the same way that borrowing money involves paying out cash in future years.)
Sir can we have not used wacc/ cost of capital since both of them would be discounted at the same rate and would would still be cheaper than the other. My text book say it is done reflecting the risk level to the lender providing finance to the company but I do understand what this means
I have already explained why we use the cost of debt when deciding whether to lease or buy.
The cost of debt is determined by the lenders and depends on how risky they perceive their investment to be. However this is not relevant for lease and buy decisions and is explained in great detail in my later lectures on the cost of capital.
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