LEASING TUTORIAL QUESTIONS

15-4
EVALUATING THE FINANCING DECISION

The analysis of whether leasing is effectively, after taxation, a cheaper form of finance than borrowing
is based on the discounted differential after-tax cash flows of each alternative. The alternative with
the lowest net present cost would then be chosen.

As the decision is a financing one, the discount rate that is appropriate is the after tax cost of debt.

15-5
DISCOUNT RATES
As the decision is a financing one, the discount rate that is appropriate is the after tax cost of debt.
While the cash flows that are associated with the investment decision are uncertain, those associated
with the financing decision are fairly certain. The major categories of cash flows are as follows:

INVESTMENT DECISION
Cost Low risk
Tax deductions Low risk
Operating costs High risk
Operating revenues High risk
Residual value High risk
Expected life High risk

FINANCING DECISION
Cost Low risk
Tax deductions Low risk
Lease instalments Low risk

As the financing cash flows are less risky overall, it is appropriate that they be discounted at a lower
rate, being the after-tax cost of debt. The investment cash flows are discounted at a higher rate being
the weighted average cost of capital.

It is important to note that the financing cost deductions as well as the depreciation deductions are
low risk only if the firm is not a one-project firm or if the projects are not ring-fenced. For example, if
a firm has R100m in net income from other projects and is considering a new project, then even if the
project fails, the company will still be able to obtain the deductions for depreciation and the financing
costs. This makes these deductions more certain of being utilised. However, sometimes for the gold
mining sector and for some leasing decisions, the depreciation deductions may be ring-fenced to the
project so that the risk of the depreciation deductions will equal in effect the risk of the project.
15-11

Cost / Loan 5,000,000 Depreciation per year SL 20%

Lease payment 1,200,000 Tax rate 28%
Maintenance 200,000 Interest rate 11.111%
Residual payment 900,000 Interest rate 8.000%
Residual value 2,000,000 JIT Ltd
Net Advantage of Leasing (NAL) 0 1 2 3 4 5
PV of Loan avoided (cost of asset) 5,000,000
Lease payment -1,200,000 -1,200,000 -1,200,000 -1,200,000 -1,200,000
Tax saving of lease payment 1 336,000 336,000 336,000 336,000 336,000
Value of maintenance expense 200,000 200,000 200,000 200,000 200,000
Tax saving on maintenance foregone 2 -56,000 -56,000 -56,000 -56,000 -56,000
Depreciation tax saving foregone 3 -280,000 -280,000 -280,000 -280,000 -280,000
Residual payment -900,000
Tax due to residual value & payment 4 -308,000
Tax on Recoupment avoided 5 560,000
3,800,000 -1,000,000 -1,000,000 -1,000,000 -1,000,000 -448,000
PV factor 1.0000 0.9259 0.8573 0.7938 0.7350 0.6806
PV of cash flows at loan interest rate 3,800,000 -925,900 -857,300 -793,800 -735,000 -304,909

Net Advantage of Leasing (NAL) 183,091

1. Lease Pmt x tax rate

2. Maintenance x tax rate
3. Cost x Depreciation rate x tax rate
4. Residual payment x tax rate
5. (Residual value - Tax value) x tax rate. The Tax value would be zero at end of Yr5.
Note: the residual values apply to both options, if the lessee makes the residual payment

Cost/opening Tax value 5,000,000 5,000,000 4,000,000 3,000,000 2,000,000 1,000,000

Depreciation 0 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000
Closing Tax value 5,000,000 4,000,000 3,000,000 2,000,000 1,000,000 0
15-11 (continued)

Alternative approach

ALTERNATIVE SOLUTION

Borrow & Purchase and Lease Options set out seperately

Borrow & Purchase R000 0 1 2 3 4 5

Cash outflow (cost of plane) -5,000,000
Loan receipt 5,000,000
Loan repayment -5,000,000
Interest -555,550 -555,550 -555,550 -555,550 -555,550
Interest tax saving 155,554 155,554 155,554 155,554 155,554
0 -399,996 -399,996 -399,996 -399,996 -5,399,996

PV of Loan -4,999,984
Residual value 2,000,000
Recoupment -560,000
Depreciation tax saving 280,000 280,000 280,000 280,000 280,000
Maintenance -200,000 -200,000 -200,000 -200,000 -200,000
Tax saving on maintenance 56,000 56,000 56,000 56,000 56,000
-4,999,984 136,000 136,000 136,000 136,000 1,576,000
PV factor 1.0000 0.9259 0.8573 0.7938 0.7350 0.6806
PV of cash flows at loan interest rate -4,999,984 125,922 116,593 107,957 99,960 1,072,626

Net Present Cost (NPC) A -3,476,926

Lease R000 0 1 2 3 4 5

Lease payment -1,200,000 -1,200,000 -1,200,000 -1,200,000 -1,200,000

Tax saving from lease payment 336,000 336,000 336,000 336,000 336,000
Residual payment -900,000
Residual value 2,000,000
Tax on (residual value - residual pmt) -308,000
-1,200,000 -864,000 -864,000 -864,000 -864,000 1,128,000
PV factor 1.0000 0.9259 0.8573 0.7938 0.7350 0.6806
PV of cash flows at loan interest rate -1,200,000 -799,978 -740,707 -685,843 -635,040 767,717

Net Present Cost (NPC) B -3,293,851

Net Advantage of Leasing (NAL) B-A 183,075 [Very small rounding difference]