CIMA F3 Course Notes Chapter 10 Lease vs Buy Personal use only - not licensed for use on courses 137
1. Leasing Leasing Leasing is a process by which a firm can obtain the use of a certain fixed assets for which it must pay a series of contractual, periodic, tax deductible payments. The lessee is the receiver of the services or the assets under the lease contract and the lessor is the owner of the assets. 2. Types of leases Finance leases A financial lease is usually written for a term near to but not exceeding the economic life of the equipment. Typical elements: Periodic lease payments made Ownership of the equipment reverts to the lessor at the end of the lease term, Not able to be cancelled, with a legal obligation to continue payments to the end of the term The lessee maintains the equipment On balance sheet (it appears as an asset on the balance sheet) Effectively a form of finance using the asset as security. Operating leases An operating lease is typically for a much shorter time frame. Typical elements are: Periodic lease payments made Ownership of the equipment remains with the leesor May be cancellable The lessor maintains the equipment Off-balance sheet (i.e. does not appear as an asset on the balance sheet rental payments are charged as an expense) Personal use only - not licensed for use on courses 138
3. Benefits of leasing Some of the benefits of leasing include: Leasing is less capital-intensive than purchasing, so if a business has constraints on its capital, it can grow more rapidly by leasing assets than by purchasing. No initial down payment is needed, whereas the loan to finance an asset purchase may require a deposit to be put down (e.g. often for mortgages on property this can be 20-30%) Capital assets may fluctuate in value. Leasing shifts risks to the lessor. Loans (used for asset purchases) may include covenants restricting operations leases do not. May allow payment over a longer period than the terms of an equivalent loan, reducing the amounts paid each period. It may be the only practical option e.g. if the asset can not be purchased, for example a building in a specific location. Protection against obsolescence (e.g. computer equipment) Greater flexibility (particularly operating leases) Leasor may be able to provide expert technical advice and maintenance support (e.g. computer equipment) 4. Lease vs Buy Calculations The key type of calculation in this area is a lease vs buy calculation where you have to decide whether to lease or buy the asset. Approach The basic approach is to do an NPV calculation of all relevant cashflows involved in leasing, and this discounted at the post tax cost of debt. A positive NPV means that the lease is cheaper than a loan. The two key relevant cashflows to include in the NPV are: Personal use only - not licensed for use on courses 139
Relevant costs of leasing vs buying Lease payments Lost capital allowances (a lost benefit if leasing not buying) Lost resale values (another lost benefit if leasing) Relevant incomes Savings on purchase price Tax reclaimable on lease payments Note the relevant discount rate is the post tax rate. If you are given a pretax rate you need to multiply this by (1-tax rate) to get the post tax rate. Example An airline is trying to decide between purchasing an new aircraft at 12m, which they will use for three years and are then be able to sell for 6m, using a bank loan at 10% pre tax, or making three equal lease payments of 2m to a leasing company starting immediately. Tax is 30% payable in the same year in which profits are made. 25% reducing balance writing down allowances are available. Solution The relevant cash flows for leasing are: Time 0 1 2 3 Relevant income Saving on price 12.00 Tax on lease payments 0.60 0.60 0.60 (30% x lease payments) Relevant costs Lease payments -2.00-2.00-2.00 Lost capital allowances -0.9-0.68-0.23 (W1) Lost resale value -6.00 Net 10.00-2.30-2.08-5.63 Discount rate 1 0.935 0.873 0.816 10 x(1-0.3) = 7% Present value 10.00-2.15-1.82-4.49 Net Present Value 1.54 A positive NPV means that leasing is the best option by 1.54m in present day terms. Personal use only - not licensed for use on courses 140
W1 Capital allowances Capital allowances are calculated by allowing 25% each year to be chargeable to tax and reducing the balance at the end of year. This can be charged against tax (assuming the company is profitable) and so there is a tax benefit of 30% of this amount. In the final year, and amount on which a claim has yet to be made is claimable. Asset cost 12 Year 1 CA @ 25% = 3 Tax saved = 3 x 30% = 0.9 Balance end Y1 9 Year 2 CA @ 25% = 2.25 Tax saved = 2.25 x 30% = 0.68 Balance end Y2 6.75 Year 3 Resale value 6 Balancing allowance 0.75 Tax saved = 0.75x 30% = 0.23 Tax treatment on interest on finance leases In some tax jurisdictions, tax is treated differently on the depreciation element of finance leases and the interest element. If for example the total of all lease payments on a 3 year contract was 18,000 and the price of the asset to purchase was 15,000: 1. Depreciation element 15,000 of the lease payments would be allowable for tax as depreciation The annual tax saving would be ( 15,000/3) x tax rate (at 30% = 1,500) Personal use only - not licensed for use on courses 141
2. The effective interest on a finance lease is: The total lease payments made purchase price of the asset. = 18,000-15,000 = 3,000 The amounts allowable for tax on this element are not the same in each year, and must be calculated using the sum of the digits method. For 3 years, add up 3 + 2 + 1 = 6. The first year has more interest so it gets 3/6 ths, the second year 2/6 ths and the last year 1/6 th as shown below. Year Calculation Interest Tax saved (e.g. at 30%) 1 3,000 x 3/6 1,500 450 2 3,000 x 2/6 1,000 300 3 3,000 x 1/6 500 150 In total then the tax savings in: - year 1 are 1,500 + 450 = 1950 - year 2 are 1,500 + 300 = 1800 - year 3 are 1,500 + 150 = 1650 Personal use only - not licensed for use on courses 142
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