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Chapter 5

Chapter 5 discusses asset investment decisions, focusing on the lease vs buy options for acquiring assets, comparing their net present values (NPVs) and cash flows. It emphasizes the importance of the post-tax cost of borrowing as a discount rate and introduces the concept of equivalent annual costs (EAC) for determining optimal replacement cycles. The chapter includes illustrations for calculating NPVs for leasing and buying options, providing practical examples for decision-making in asset financing.

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14 views2 pages

Chapter 5

Chapter 5 discusses asset investment decisions, focusing on the lease vs buy options for acquiring assets, comparing their net present values (NPVs) and cash flows. It emphasizes the importance of the post-tax cost of borrowing as a discount rate and introduces the concept of equivalent annual costs (EAC) for determining optimal replacement cycles. The chapter includes illustrations for calculating NPVs for leasing and buying options, providing practical examples for decision-making in asset financing.

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brianrugema
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© © All Rights Reserved
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Chapter 5

Asset investment decisions and capital rationing

Lease vs buy
When acquiring an asset for an investment project, there are two options available, either to buy
or lease the asset. The NPVs of the financing cash flows for both options are found and
compared and the lowest cost option selected.
Leasing implies that the asset is not owned by the user company from the tax authorities’
perspective. The relevant cash flows are the lease payments and the tax relief on the tax
payments. For the buying option, it is assumed the buying company requires bank loan. The
relevant cash flows in this case are the purchase cost of the asset, any residual value of the asset
and any associated tax implications due to the tax-allowable depreciation.
Buying requires the use of a bank loan and the user is the owner of the asset. The user will
receive tax-allowable depreciation on the asset and tax relief for the interest payable on the loan.
The relevant cash flows would be the purchase cost, any residual value and any associated tax
implications due to tax-allowable depreciation.

Cost of capital
As interest payments attract tax relief the post-tax cost of borrowing is used as discount rate. The
same rate is used for both leasing and buying, thus reflecting the risk level to the lender of
providing finance to the company. The post-tax cost of borrowing = cost of borrowing * (1 – Tax
rate). Where the company is not paying tax, the pre-tax rate would be applied.
Replacement decisions using equivalent annual cost and equivalent annual benefit
Once a decision has been made to acquire as asset for a long-term project, it is quite likely that
the asset will need to be replaced periodically throughout the life of the project.
The problem that arises is where equivalent assets available are likely to last for different lengths
of time or an asset, once bought, must be replaced at regular intervals. The bigger issue then is
on how often the assets should be replaced.

Equivalent annual costs (EAC)


To deal with different timescales, the NPV of each option is converted into an annuity or an
equivalent annual cost. The equivalent annual cost is the annual cash flows (annuity) to which a
series of uneven cash flows is equivalent in the present value terms.
EAC = PV of costs/Annuity factor
The optimum replacement period or cycle will be the period that has the lowest equivalent
annual cost (EAC), although in practice, other factors may influence the final decision. The
method involves calculating the NPV of each strategy or replacement cycle, calculating the EAC
of each strategy and choose the strategy with the lowest EAC.
Key assumptions:
 Cash flows from trading are ignored since they will be similar regardless of the
replacement decision and in practice, older assets may result in lower quality which in
turn could affect sales
 The operating efficiency of the machines will be similar with differing machines or with
machines of differing ages.
 The assets will be replaced in perpetuity or at least into the foreseeable future.

Illustration
Walshey Co has already decided to accept a project and is now considering how to finance it.
The asset could be leased over four years at a rental of $36,000 per year, payable at the start of
each year. Tax is payable at 30%, one year in arrears. The post-tax cost of borrowing is 10%.
Required:
Calculate the net present value of the leasing option.

Illustration 2:
A firm has decided to acquire a new machine to neutralise the toxic waste produced by its
refining plant. The machine would cost $6.4 million and would have an economic life of five
years. Tax-allowable depreciation of 25% per year on a reducing balance basis is available for
the investment. Taxation of 30% is payable on operating cash flows, one year in arrears. The
firm intends to finance the new plant by means of a five-year fixed interest loan at a pre-tax cost
of 11.4% per year, with the principal repayable in five years’ time. As an alternative, a leasing
company has proposed a lease over five years at $1.42 million per year payable in advance.
Scrap value of the machine under each financing alternative will be zero.
Evaluate the two options for acquiring the machine and advise the company on the best
alternative.

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