>studynotes

MANAGEMENT ACCOUNTING –
Financial strategy
William Parrott proposes a structured approach to tackling questions
on a common topic that many students find hard: the buy/lease decision.
A choice between leasing and buying an leasing or buying an asset. It won’t cover n Calculate the NPV of the cost of
asset can be viewed as a finance decision. the relative merits of operating and financial leasing the asset. The basic cash
An investment decision will normally have leases or go into great detail on the tax flows to include here are the periodic
been made beforehand, which is likely to consequences, which differ from country lease charge and the tax relief on the
have involved the calculation of the net to country. lease charge.
present value (NPV) of all the cash flows that The best way to make a fair comparison n Choose the cheaper of the two
would arise from obtaining and using the between the costs of acquiring the asset alternatives. The option with the lowest
asset. In most P9 exam questions concerning through purchasing and the costs of NPV of cost is the preferred method of
buy/lease decisions, the scenario indicates acquiring it through leasing is to take the obtaining the asset.
that a positive NPV has already been following three-step approach: All cash flows that will arise from
calculated for the investment decision n Calculate the NPV of the cost of actually operating the asset are usually
(usually based on the assumption that the buying the asset. The basic cash flows ignored, so the labour costs of operating
asset will be purchased), indicating that the to include here are the initial asset cost, the asset and the materials it will use are left
company will benefit from using the asset. any tax savings that will arise as a result out of the analysis. Only the cash flows that
The scope of this article is restricted to of purchasing the asset and any residual arise directly from acquiring the asset are
a comparison of costs and benefits of value that’s expected. included. This is because the operational

Sample question
A construction company has conducted
an investment appraisal on a four-year
project and has decided to proceed with it.
The project involves the acquisition of
equipment that could be purchased for
£200,000 and is expected to have a
residual value of £68,000. It is estimated
that maintaining the asset will cost £8,000
in the first year and that this will increase
by 50 per cent on a compound basis in
each of the following years.
Alternatively, the asset could be leased
for £48,000 a year, payable in advance.
After four years it would be returned to the
leasing firm, which would be responsible
for all maintenance.
The company is subject to tax at 30
per cent, payable one year in arrears.
Tax depreciation allowances are available
to the purchaser of a business asset at
25 per cent a year on a reducing-balance
basis. The company can borrow at a rate
of 11.4 per cent.
You are required to determine whether
it will be cheaper for the company to lease
or to buy the asset.

50 financial management
 PAPER P9

cash flows will already have been considered 1 Tax savings on tax depreciation allowances
in the original investment decision.
The discount rate to be used when £000 Saving at 30% (£000) Timing
calculating the NPV in the first two steps is Initial cost 200.0 
the lessee’s after-tax cost of debt. This Year 1: 25% (50.0) 15.0  End of year 2
assumes that leasing is seen as a substitute
150.0
for borrowing to buy the asset, and that
leasing and borrowing to buy an asset carry Year 2: 25% (37.5) 11.2 End of year 3
a similar level of risk. The company’s normal 112.5
cost of capital is not generally used, because Year 3: 25% (28.1) 8.4 End of year 4
this discount rate reflects the operational 84.4
risk of the business whereas the cash flows
Year 4: balancing allowance (16.4) 4.9 End of year 5
to be evaluated in the finance decision carry
Residual value 68.0
less operational risk and do not, therefore,
warrant such a high discount rate.
The tax savings arising on purchasing the
asset should be calculated in accordance 2 Cash flow table for asset purchase
with the tax regime detailed in the question.
You should assume that the lease charge is £000 Start End of End of End of End of End of
fully deductible for tax purposes. year 1 year 2 year 3 year 4 year 5
Complications will often arise in both real Initial cost (200.0) 
life and in the exam. If you keep in mind that Tax savings 15.0 11.2 8.4 4.9
the aim is to create a fair comparison Residual value 68.0
between the costs of purchasing and those
Maintenance (8.0) (12.0) (18.0) (27.0)
of leasing, you should be able to adjust for
such complications. For instance, a leasing Tax relief on maintenance 2.4 3.6 5.4 8.1
firm will often provide a full maintenance Net cash flow (200.0) (8.0) 5.4 (3.2) 54.8 13.0
contract with an asset. If this is the case, you 8% discount factors 1 0.926 0.857 0.794 0.735 0.681
should include an estimate of maintenance Present values (200.0) (7.4) 4.6 (2.5) 40.3 8.9
costs in your calculation of the NPV of cost
Net present value (156.1)
to buy. In this way, both options will have
accounted for maintenance costs and the
comparison will remain fair. Obviously, in an 3 Cash flow table for asset leasing
exam this estimate of maintenance costs
would have to be provided by the question. £000 Start End of End of End of End of End of
You should also remember that maintenance year 1 year 2 year 3 year 4 year 5
and other similar costs will attract tax relief Lease charge (48.0) (48.0) (48.0) (48.0) 
and so create a saving. Tax saving on lease charge 14.4 14.4 14.4 14.4
With all this in mind, let’s tackle the Net cash flow (48.0) (48.0) (33.6) (33.6) 14.4 14.4
sample question in the panel on the opposite
8% discount factors 1 0.926 0.857 0.794 0.735 0.681
page. Our initial calculation should be to
make an adjustment to reflect the fact that Present values (48.0) (44.4) (28.8) (26.7) 10.6 9.8
interest is tax-deductible. The post-tax cost Net present value (127.5)
of debt is as follows: 11.4% × (1 – 0.3) ≈ 8%.
To work out the NPV of the cost to buy, one tax computation, which will be calculated that the net cost of purchasing the asset and
we need to calculate the tax savings on tax at the end of that year. This tax saving will maintaining it is approximately £156,100.
depreciation allowances (see table 1). In become a cash flow at the end of year two, Note that no interest or repayment of capital
doing so, we must assume that the asset is because tax is paid one year in arrears. cash flows are shown in the cash flow table,
purchased at the start of year one. Hence it The next stage is to work out the cash because the discount rate used reflects the
will first give rise to a tax saving in the year flows, as in table 2. From this we can see cost of borrowing. We have also assumed

financial management 51
>studynotes PAPER P9

that the asset’s maintenance costs are paid n Leasing may in effect provide a source of asset has a long useful life and is unlikely
at the end of every year. finance to companies that may be to become technologically obsolete.
Now we need to work out the NPV of the suffering capital rationing and would find it n Assuming that the purchase can be
cost of leasing the asset, again by using hard to raise the finance to buy the asset. funded from cash, buying an asset avoids
cash flows. From constructing table 3 on n Leasing will rarely require restrictive the periodic lease charge, which increases
page 51 we can see that the net cost of covenants or security, which may be the company’s fixed operating expenses.
acquiring the asset through leasing, which required if debt is raised. Remembering that the finance decision
includes all maintenance costs, is n Even if funds are borrowed to buy (the choice between leasing or
approximately £127,500. an asset, there is normally buying an asset) follows on from
Note that the lease charge at the outset is a significant deposit the investment decision
the fee for the first year paid in advance. This required, whereas that the asset is wanted,
will be included in, and give rise to, a tax leasing effectively and then following the
saving in the tax computation for year one, finances 100 per step-by-step approach
which will be calculated at the end of that cent of the I have suggested,
year. This saving will become a cash flow at amount required. should help you to
the end of the second year, since tax is paid n Leasing is often handle questions of
one year in arrears. administratively this nature. You should
This NPV could be worked out more less complex also ensure that you
quickly using annuities. Students confident in than borrowing. understand why leasing
calculating the present value of advanced n Leasing may be off- or buying may have a
and delayed annuities could save themselves balance sheet. This cost advantage and what
time here by doing so. depends on the accounting other benefits may arise from
So it seems from our calculations that regulations in the country each approach.
leasing the asset would be £28,600 concerned, but typically assets It’s notable that other, more complex
(£156,100 – £127,500) cheaper than acquired through an operating lease need financing methods have been suggested as
purchasing it. In this case the leasing option only be disclosed in the notes to the potentially cheaper ways to obtain assets.
would also be more advantageous because accounts and aren’t shown on the face of Such approaches could give a project that
the company would not be affected if the the balance sheet. is currently not worthwhile a positive NPV.
asset’s maintenance costs were higher than But buying an asset may still remain the But using clever financing methods to make
expected or its residual value turned out to most attractive option for a company. The doubtful projects marginally attractive can be
be lower than expected. reasons for this include the following: a dangerous road to take. This is why I would
As our worked example has shown, n The purchasing option gives the company always recommend considering the
leasing may potentially be a cheaper way for an asset on the balance sheet and total investment decision first – it ensures that a
a company to acquire an asset. The reasons control over how it’s used. A lease may be project is inherently attractive before there is
for this include the following: more restrictive – varying its terms could any consideration of how to finance any
n The leasing firm may be able to buy the incur extra fees. assets it may require.
asset and/or arrange the maintenance at n Buying may confer tax advantages.
a more attractive cost owing to its bulk Whether or not this is the case depends on William Parrott is a tutor at Kaplan
purchasing power. the tax regime in the country concerned. Financial. He taught the first-prize-winning
n The leasing firm may be able to borrow n The total cost of buying may be lower. This student in the May 2008 P9 paper and a
the funds required to finance the is most likely to be the case where the joint first-prize winner in November 2008.
acquisition of the asset at a more
attractive interest rate than the potential P9 further reading
lessee could.
n The leasing firm may be subsidised by R Pike and B Neale, Corporate Finance and Investment: Decisions
the manufacturer of the asset in order to
promote the use of its products.
and Strategies Financial Times/Prentice Hall, 2005.
n Leasing may confer tax advantages. R Brealey and S Myers, Principles of Corporate Finance, McGraw-
Whether or not this is the case depends Hill Education, 2002.
on the relevant national tax regime. J Ogilvie, Management Accounting – Financial Strategy CIMA Official
n Leasing is a highly competitive industry Learning System, CIMA Publishing, 2008.
which tends to force prices down.

financial management 53