- 15 Marks
Question
MK Plc is considering the best way to finance the replacement for a particular high specification piece of equipment that has become too costly to maintain. The replacement equipment is estimated to have a useful life of 4 years with no residual value after that time.
Two alternative financing schemes are being evaluated:
- Scheme A: Buy the equipment outright funded by a bank loan
- Scheme B: Enter into a four-year finance lease
Scheme A: Buy outright, funded by a bank loan
MK Plc could purchase the equipment outright at a cost of N200 million on July 1, 2016. MK Plc can normally borrow at an annual interest rate of 13% per year.
Scheme B: Four-year finance lease
The equipment would be delivered on July 1, 2016, and MK Plc would pay a fixed amount of N58,790,000 each year in advance, starting on July 1, 2016, for four years. At the end of four years, ownership of the equipment will pass to MK Plc without further payment.
Other Information:
- MK Plc has a cost of equity of 20% and WACC of 16%
- MK Plc is liable to company tax at a marginal rate of 30%, which is settled at the end of the year in which it arises
- Tax depreciation allowances on the full capital cost are available in equal instalments over the first four years of operation
You are required to:
a.
Calculate which payment method is expected to be cheaper for MK Plc and recommend which should be chosen solely on the present value of the two alternatives as at July 1, 2016. (13 Marks)
b.
Discuss the appropriateness of the discount rate used in (a). (2 Marks)
Answer
a) Financial evaluation of the two options.
Scheme A. The relevant cost is simply the cost of the equipment i.e. ₦200million
Scheme B. Finance lease – a number of steps are needed here:
i) Implied interest rate
The implied interest rate on the lease is computed as follows:
From the annuity tables, a 3-year cumulative present value of 2.402
corresponds to approximately 12%. Therefore, the implied interest on the lease is 12%.
iii) Tax savings on interest
iv) Discount rate. The discount rate to use is the cost of borrowing, net of tax = 13 (1 – 0.30) = 9.1%
v) NPV of lease option
Note: The above calculations are based on differential cash flows. We have therefore ignored tax savings on tax depreciation. Whether the company buys the equipment by borrowing or adopts a finance lease, it is entitled to tax depreciation on the equipment. If the relevant tax savings are incorporated into the analysis, the result will be as follows:
It is clear that the relative position of the two alternatives remains the same.
Conclusion: The leasing option offers a cost savings of ₦1,768,000 relative to the purchase option and it is therefore the preferred option.
b) Discount Rates for Financing Decision:
The two primary discount rates to consider are:
When evaluating the investment in the equipment, project-specific risks will already have been accounted for. The analysis in part (a) is intended to support the financing decision, not the investment decision. Therefore, cash flows should be discounted using either the WACC or a project-specific discount rate when evaluating the investment decision. This is because the project is financed through a mix of the company’s debt and equity resources. However, the financing decision is separate, and the discount rate should be chosen accordingly.
For financing decisions, we typically use the cost of debt as the baseline. Other financing options, such as leasing, should be compared against the cost of debt, which serves as the discount rate. The post-tax cost of debt reflects the opportunity cost of leasing and can be used to discount the incremental cash flows that arise from leasing, in comparison to buying the equipment outright.
Alternatively, leasing could be used as the baseline for comparison, and the post-tax implied cost of leasing could be used as the discount rate. However, in practice, it is generally simpler to discount cash flows using the post-tax cost of debt.
- Tags: Discount rate, Equipment Financing, Financing, Lease, Loan, Present Value
- Level: Level 3
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