1
Price Saved Payment Payment Lost On Tax Interest Value
After Tax WDA Rate)
0 10 -2.4 -1.44 0.0000 8.5600 1.0000 8.5600
1 -2.4 -1.44 2.5000 -1.0000 -2.4400 0.9328 -2.2761
2 -2.4 -1.44 1.8750 -0.7500 -2.1900 0.8702 -1.9057
M.Sc. Finance
Finance IV: Tutorial 1
SOLUTIONS
For all questions in this exercise you are required to calculate the present value of leasing relative to buying
the asset using the after-tax discount rate and ignoring debt displacement. We will return to the issue of
displaced debt next week.
Leasing
1. A project requires an investment in capital equipment of Ā£10m and can be expected to produce an
annual net cash flow before tax of Ā£3.6m for each of the next five years. The equipment can be leased on
the basis of five lease payments of Ā£2.4m, the first of which will be due when the equipment is acquired.
The equipment qualifies for a 25 per cent writing down allowance, and the tax rate is 40 per cent. The
company can borrow at 12 per cent and its weighted average cost of capital is 18 per cent.
a) As the projectās net cash flow exceeds the leasing charge does this imply that the investment and
leasing proposals are both profitable?
The leasing is a form of financing and should be analysed separately from the underlying
investment. It is possible that the underlying investment is very profitable and on this basis its cash
flows could be greater than the payments required by a very expensive (unprofitable) lease. If the
investment and the lease are considered together the analysis will fail to identify whether or not the
investment is in essence cross subsidising an unattractive lease proposal. Moreover, the risk
character of the lease payments and the investment net cash flows differ. As a result nothing in
principle can be inferred about the profitability of the investment or the lease from an observation
that the expected net cash flows of an investment exceed those of the lease.
The net cash flows of an investment can exceed the lease payments and the lease may not be
profitable. Similarly observing that the next cash flows of an investment exceed the required lease
payments does not indicate that the investment is profitable leasing. If the investment is risky the
required return will be high and its NPV may well be negative. The lease payments in a highly
competitive market will reflect the general ability of the company to make the lease payments, and
will not reflect the risks of the investment it is being used to fund. In this exercise the figures were
chosen to produce an outcome that the lease is profitable but the investment is not!
Evaluation of Lease
Purchase Price 10
Lease Payment 2.4
No. Of Payments 5
Tax Rate 0.4
Interest Rate 0.12
WDA 0.25
Years Purchase Lease Lease WDA Tax Saving NCF PVF (After Present
