Lecture Notes on Lease vs Buy Decision

Key Concepts:

• Focus: Comparison between leasing and buying a machine.
• Goal: Determine the cheaper option between leasing and buying by setting up cash flows and calculating the present value of costs.

Example Scenario:

• Machine Cost: $100,000 if bought.
• Lease Cost: $35,000 per year, payable at the start of each year.
• Duration: 4 years.
• Scrap Value: $10,000 if bought.
• Interest Cost: 7% after-tax interest cost for borrowing money.
• Tax Rate: 30% payable one year after the financial year-end.
• Capital Allowances: 25% reducing balance.

Approach to the Decision:

1. Set Up Cash Flows:

   • Lease Payments: Considered at the start of each period (time 0, 1, 2, 3).
   • Buying: Immediate $100,000 cost at time 0, with $10,000 scrap value in year 4.

2. Tax Implications:

   • Lease payments reduce taxable income, leading to tax savings.
   • Tax savings from lease payments are calculated as 30% of $35,000 = $10,500 per year.
   • Timing of tax savings is critical:
     • Calculated end of accounting year; realized one year later (e.g., first saving at time 2 for initial payment).
   • Capital Allowances:
     • Calculated at purchase (e.g., year ended December 2016).
     • Tax effect of capital allowance occurs one year later.

3. Present Value Calculation:

   • Leasing:
     • Cash outflows: -$35,000, net -$24,500 annually.
     • Tax savings inflow of $10,500 starts from time 2.
     • Total present value of leasing = -$93,607.
   • Buying:
     • Cash outflow: -$100,000 initially, with $10,000 inflow in year 4.
     • Capital allowance savings reduce net cost.
     • Total present value of buying = -$69,960.

4. Decision:

   • Cheapest Option: Buying the machine (lower present value cost of $69,960 vs leasing $93,607).

Additional Notes:

• Tax Timing Complexity: Primary challenge due to timing of tax effects.
• Discount Rate: Use after-tax interest cost for discounting (7% in this case).
• General Rule for Tax Timing:
  • First cash flow first day of accounting period: tax effect at time 2.
  • First cash flow last day of accounting period: tax effect at time 1.

Conclusion:

• The leasing vs buying decision involves careful consideration of cash flows, tax implications, and present value calculations to determine the most cost-effective option.
• Understanding and applying the correct timing for tax savings is crucial in making an informed decision.