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Hello,
I am now trying to understand the answer to below question as given here:
Why is the interest rate on borrowing ignored when calculating present value of the cost of borrowing?
Thank you in advance.
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Question:Spot Co is considering how to finance the acquisition of a machine costing $750,000 with an operating life of five years. There are two financing options.
Option 1
The machine could be leased for an annual lease payment of $155,000 per year, payable at the start of each year.
Option 2
The machine could be bought for $750,000 using a bank loan charging interest at an annual rate of 7% per year.
At the end of five years, the machine would have a scrap value of 10% of the purchase price. If the machine is bought, maintenance costs of $20,000 per year would be incurred.
Taxation must be ignored.
Required:
Evaluate whether Spot Co should use leasing or borrowing as a source of finance, explaining the evaluation method which you use. (10 marks)You must not post links to pirate websites – the website you link to is illegally hosting material that is copyright of the ACCA.
You should be using a Revision Kit published by one of the ACCA approved publishers and not using pirate websites.The answer has not ignored the interest rate of borrowing – the cash flows have been discounted at the cost of borrowing!! The whole reason for discounting is to account for the cost of money.
I do suggest that you watch my free lectures on lease v buy. The lectures are a complete free course for Paper F9 and cover everything needed to be able to pass the exam well.
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