CIMA F3 Syllabus B. Sources of long term funds - Lease or Buy - Notes ^{14 / 15}

Simply choose the one with the lowest NPV cost (as asset revenues will be the same for both methods)

Let’s have a look at what are the relevant costs here

Unless the company does not pay tax - use the after tax cost of borrowing

= Interest rate x 70% (if tax is 30%)

*Note that the cost of the loan should not include the interest repayments on the loan

Illustration

Machine cost $6,400 (UEL 5 years)

Capital allowances 25% reducing balance

Finance choices

5 year loan 11.4% pre tax cost or
5 year Finance Lease @ $1,420 pa in advance

• Solution

  Buy using the Loan

Post Tax borrowing

• 11.4% x 70% = 7.98% = 8%

  Cost = (4,984)

Option 2 - Lease

• Cost (4,548)

The cheapest option is the lease

Leasing benefits in general

1. Allows company to get the asset if they can’t get a bank loan

2. Some taxation benefits (Tax exhaustion)

3. Avoids regulations that other lending can give such as covenants etc

Operating Lease Features

1. Possibility of short term rental

2. No initial capital outlay

3. No risk of obsolescence

4. Often maintained & insured by the lessor

5. Off balance sheet finance

6. Can be expensive

Finance lease features

1. Long term rental

2. No need for initial capital outlay

3. Simply an alternative source of finance

4. May be cheaper