this is a lecture from open tuition to benefit from the lecture you should download the free lecture notes from open tuition com alright this is the third the last lecture on chapter 9 where if you remember we're looking at these three special situations we've already dealt with come to rationing replacement and the last one is lease versus buy which watch me carefully as I go through although the idea behind this I think is very straightforward I hope so there is one problem the examiner keeps throwing in a little Y which relates as you'll see to the the tax situation anyway I don't just spoil the firm look at the example with me and I'll explain the problem when we come to it a company is considering example three a company is considering whether to buy a machine at a cost of $100,000 natively to lease it for thirty five thousand a year and the lease payments are payable at the start of each year remember normally we assume revenues and costs at the ends of years but here we're told specifically that the lease payments effectively the rent if we rent the machine I'm going to be paid at the start of each year now buying it will involve borrowing money as an after-tax interest cost of seven percent if the machine is bought it can be bought on the last day of the current financial year the machine will be needed for four years and if we buy till I'm a scrap value after four years of ten thousand taxes 30% payable one year after the end of the financial year and capital announces are 25% reduce imbalance well what are we concerned about we need this machine and we want to know whether to buy it or effectively rented buy or lease whichever is that the best is gonna be whichever stitute of the two I'm not concerned about the revenues will generate from this machine because whether we buy it or release it presumably will have the same production and get the same operating profits and sales period cost exercise which is going to be cheaper buying it hundred thousand and then getting the scrap or leasing it paying thirty five thousand a year well what we'll do is we'll set up the cash flows for each of them well work out the present value of the costs and see which is the cheaper of the two what about leasing the cost that the cost involved in leasing these lease payments and we'll know the lease payments we're having a family yes for years zero one two three four I'll be careful though it says I did mention before we're paying thirty five thousand a year normally going expenses at the ends of that would be at the ends of the year so Taiwan time Tucson but if we're paying at the start of the year the start of the first year is now time zero the start of the second year it starts in one year's time time one the third year starts in two years time and the forth year starts in three years time so there are the flows if we lease it now there is going to be a tax effect we'll worry about tax in a moment I'll leave a big space but let's work out what the cash flows will be if we buy it not one two three four well of course if we buy it we pair up the initial cost now how much is it 100,000 and we get the scrap proceeds since it's ours we'll get the scrap proceeds in four years time an inflow of 10,000 now again there are tax implications which is where we have a bit of a problem we'll worry about mounting to sales but otherwise I think easy enough and one legal point which worries people the lease payments there at the start of each year so just suppose some thus the you know we come to have different year ends but suppose the start of the first year was that say the first of January 2017 when he says we we the alternative is to bite it says if he bite it can be on bought on the last day of the current financial year well since we haven't yet made the decision the current year is 2016 so in actually be paying for it on 31st December 2016 and some people get terribly worried and say go woods 2017 is a year later on 2016 but I know it no that's but not in these days surely there's December 2016 first there's only a day apart and from a discounting point of view it's effectively the same day we never discount for one day we're not worried about one day so time zero I don't really care whether it's December 16 or whether it's January 17 same thing there could be other flows you know if maybe if we buy it we would have to pay repairs maybe if we lease it we don't have to pay the repairs no problem if I told you leasing that would no other customers buying you've got repairs of two thousand a year fine it's ticking extra flow so two thousand a year however where we need a bit more is in relation to the tax effect because there is tax payable at thirty percent one year after the end of the financial year and as far as the lease payments are concerned we do assume that lease payments are allowable for tax now as humor always as I said in an earlier chapter we assume the company's already making lots of profits and paying lots of tax if we lease we've got this extra expense which will reduce our proper existing profits and if our existing profits go down we'll be paying less tax will save tax and so would there be a tax saving on those payments and the tax saving each year since taxes thirty percent thirty percent of 35,000 is how much 10500 so taxable profits are lower our tax bill miss Laura so we save tax at ten thousand five hundred a year but here be careful when are we going to make the savings taxes payable one year after the end of the financial year so surely the way tax works if the first lease payment is the first of January 2017 they'll calculate our tax bill at the end of the accounting period so the tax had be calculated on the 31st of December 2017 when the bells must have generated they don't calculate tax till the end of the accounting year and the taxes payable one year after the end of the accounting year so it's going to be paid or in this case saved on December 2018 and what time period with that January 17 to December 17 well December 17 is one year away December 18 is two years away so the tax saving the first tax saving would be a time to because the 35,000 is paid at the start of the year tax is calculated at the end of the year one year later payable another year later so it's two years later so similarly time what the defendant time one tax benefit two years later time three time to two years later at time 4 at time three two years later at time at five and there's a bit of thought I will give you a rule at the end but it's only ever in least by questions that this tax timing has been a problem it's because otherwise as you'll see the question is so easy I think the only way you can find of making it a bit trickier is this a tax timing problem however the net cash flows as a result if we lease outflow of 35:35 and net outflow of twenty four five hundred and then because it's tax savings effectively inflows of ten and five all right now let's turn toward terms if we bite well the basic flow is easy cost two hundred the scrub for but again what about tax because you know from an earlier chapter if we buy something we get capital allowances and so will save tax that way so we'll have the tax saving on capital allowances well you know how to calculate let's do it I have to do workings the initial cost is a hundred thousand the first capital allowance calculation 25 percent is it 20 years 2007 losing balance 25 thousand bringing the tax now you'd have 75 we want the tax saving we're the tax rate of 30% the first cut allowance will make a saving of seven five hundred now in a minute I'll carry on you know twenty five percent each year however again we need to think carefully about the timing because this is old when was the Machine bought it was Lord on the last day of the financial year which as an example I said suppose is December 2016 well I know you might not all over done may perhaps inks but you always get capital ounces calculated in the year in which you bought the machine doesn't matter when you buy during the year whether you buy to the beginning in the middle at the end we bought this machine in year ended December 2016 the allowances would therefore be calculated at the end of the year that we calculated immediately December 2016 when will the tax effect take place well as a one-year delay the tax rate is one year after the accounting period and so the tax effect will be a time one now say I will give you a rule later but it's only lease those aspiring questions with on this problem but the first candle and saving will be time one less now carry on is twenty five percent each year twenty five percent of seventy five thousand eighteen seven fifty and so the tax saving that the results and 30 percent 562 five there brings the tax value down to 56 to 50 well I'll put the figures on my schedule later let's finish the calculations but before we carry on before we rush along if you take up separate half percent 20 percent remember it'll be 25 percent each year until the final year and in the final year of last year we simply subtract the sale proceeds but the question is how many years are we gonna do people say only interpreter before the machine four years of the world and I'll tell you why we bought it on the last day of the current year and so they expended minutes ago we'll get allowances and saving the money either plus one year we then used a machine for four years and we'll get allowances for each of the four in total will be five years allowances will do 25 percent each year until the last year the fifth year when we have the balance of charge so let's carry on the third year 25 percent of 56 to 50 40 no 63 and so the saving for two one nine and the tax ring down value is now 42 187 the fourth year they allows his ten five four seven the saving therefore three one six four so the tax value comes down to thirty one 6040 finally though the fifth the last year we don't have twenty five percent we subtract the sale or the scrap proceeds which are ten thousand I remember the difference whatever select is a balancing allowance for a bouncing charge here the scrap value is less than the tax value so there's a balancing allowance of twenty one 640 and therefore we'll save tax at thirty percent of that six 492 left stick those in the schedule and then we're almost there the tax savings seventy five hundred five six two five nine two four two one nine three one six four and at time five what was it six four nine two six four nine two if you still worry about the tax I'll give you a rule later but does to say so me these questions that it becomes a problem but I'll give you that later the net cash flows there we are all right we've got the net cash flows under each possibility leasing and find the final thing is how we're going to decide which is better we want the one that's the cheapest but how we're going to decide well we'll decide by discounting and we discount always at the after-tax interest cost of borrowing they says here the cost of borrowing money is 7% after-tax will discount in both cases at 7% now before I'm due because the discounting itself is obviously just using the table such shouldn't take many signals the point is and we'll say a lot more about the cost of money in later chapters there's a lot to do on it the point is we might be paying interest at let's say 10% but because interest reduces tax or profits because interest pay more interest saves you tax although you might be paying interest at 10% you'll save tax at 30% of it and therefore after tax it's effectively only costing 7 so we'll discount to the after-tax interest here you've given after tax interest if he had said the interest before tax is 10% then you would have taken off 30% you'll discover 7 so let's do it and then like a type of themselves where my discount the discount has a 7% for one year point nine three five two years eight seven three eight one and six seven six three seven one and three the present values therefore be careful with the signs here better check out don't make a silly mistake 35,000 times point nine three families we've got 500 tons 1973 24500 times point 81 sinks 10500 times point seven six three and finally ten five hundred times point seven one three the overall present value of leasing ninety-three 607 appreciate its negatives to cost you know we're ignoring their whatever revenues being generated because that will be the same whether we choose to buy or we choose to lease so all we want to know is which is the cheapest cost of the - well leasing effectively is 93 607 finally buying again with discount factors the present values seven five hundred times point nine three five seven oh one three five six to nine times nine to eight seven three four nine one one four two one nine times point eight one six three double for three thirteen one six four times point seven six three ten thousand and forty four and finally for six to nine and so again the total present value if we buy 69 960 and so now we can make the decision as I've said a couple of times we want the cheapest cost of the two it could obviously be either but in this case leasing effective in ninety three thousand buying only sixty nine thousand the cheaper of the two is to buy so there we are now as I was saying earlier I think I hope you'd agree that this is all desperately easy apart from the tax timing it's that that's the problem if there's no tax in here this question to be obvious if you've been through the earlier chapters this question really should have been a joke but it's the tax is the only thing that makes it tricky and I've said several times this tax timing has only been a problem in the exam when there's been at least by question and so all I can do I mean go back and listen to what I said when I explain the logic but as a rule if there's a one-year delay in tax that's the rule let's go excessively the most common one taxes payable one year after the end of the financial year if the first cashflow is on the first day of an accounting period then the first tax effect is it time - that was the situation in releasing the flow at the start of the period the tax calculation is at the end of the period which is a year later the tax effect or one year delay another year later time - on the other hand if the first cash flow is on the last day of an accounting period then again with the one-year delay tax the first tax effect is it time one this is what time with the gap the Lance's first class Club was at the end of the accounting period because it's not I said the period immediately the tax will be calculated but because of a one-year delay payment the tax effect we on year later at Taiwan so there's the rule from the last time it's only leased by where that's ever been a problem in the exam there and I'm not going to explain the reason again it's still wearing you look back listen to what I was saying as we went through it anyway there there's three special cases there's only one more aspect of investment appraisal we need to account which is the next chapter relieving that uncertainty