CHAPTER 5 CLASS EXAMPLE 1 SOLUTION [25 marks]

1.1
Discount rate
Before tax cost of debt = 7% per annum
After tax cost of debt = (Before tax cost x 1 – tax rate)
= 5.04% (rounded to 5%) ()

TAX ALLOWANCE (WEAR AND TEAR)

Tax Value Carrying Amount
R ‘Million R ‘Million
Cost 12 12
Tax allowance / Depr. x 20% - year 1 (12) (2.4)
Value end of year 1 ----- 9.6
Tax allowance / Depr. x 20% - year 2 (2.4)
Value end of year 2 ----- 7.2
Tax allowance / Depr. x 20% - year 3 (2.4)
Value end of year 3 ----- 4.8
Tax allowance / Depr. x 20% - year 4 (2.4)
Value end of year 4 ----- 2.4
Tax allowance / Depr. x 20% - year 5 (2.4)
Value end of year 5 ----- -----
Residual = Zero (provided in question) (must be included in Cash Flow Table)
Recoupment / Scrapping allowance = Zero – Zero = Zero (must be included in Tax
Calculation Table)

SCHEME A - BORROW AND BUY

TAX CALCULATION
R Million 0 1 2 3 4 5
Wear & Tear (R12m x 100%) (12) ()
Recoup. / Scrapping Allow. (-----)
(12) ----- ----- ----- -----
Tax at 28% 3.36
Tax Refund / (Paid) ----- 3.36

CASH FLOWS
R Million 0 1 2 3 4 5
Initial Cost (12) (½)
Residual -----
Tax (from Tax Calculation) 3.36 (½)
Total (12) ----- 3.36 ----- ----- -----
Discount rate = 5% NPV = (R8.95 Million) (using a financial calculator) ( If correct)
Discount rate = 5.04% NPV = (R8.95 Million) (using a financial calculator)

SCHEME B – LEASE

1. Actuarial Method of Calculating the Implicit Interest Rate

PV = - R12 Million
N=5
I/YR = 9%
PMT = R3.09 Million ()
Reasonable in terms of the payment provide in the question of R3 million.
N.B.! Use the Amortisation Function to obtain the annual interest payments.
QUESTION 1 (CONTINUED) [25 marks]
ALTERNATIVE 2 – LEASE (CONTINUED)
1. Actuarial Method of Calculating the Implicit Interest Rate
Year Opening Closing
Balance Payment Capital Interest Balance
(R Million) (R Million) (R Million) (R Million) (R Million)
1 12 3.09 2.01 1.08 9.99
2 9.99 3.09 2.18 0.91 7.81
3 7.81 3.09 2.38 0.71 5.43
4 5.43 3.09 2.60 0.49 2.83
5 2.83 3.09 2.83 0.26 -----
Total (CE) 15.45 (CE)12.00 (CE) 3.45

2. Sum of Digits Method

Total interest = Payments – Initial Cost
= R15 Million – R12 Million
= R3 Million
Sum of digits = Sum of the number of years
=5+4+3+2+1
= 15
Annual interest = R3 Million ÷ 15 years x Years remaining on lease ()
Year Opening Closing
Balance Payment Capital Interest Balance
(R Million) (R Million) (R Million) (R Million) (R Million)
1 12 3.00 2.00 1.00 10.00
2 10.00 3.00 2.20 0.80 7.80
3 7.80 3.00 2.40 0.60 5.40
4 5.40 3.00 2.60 0.40 2.80
5 2.80 3.00 2.80 0.20 -----
Total (CE) 15.00 (CE)12.00 (CE) 3.00
NOTE:
Either the actuarial method or sum of digits method needs to be prepared.
As the lease has an implicit interest rate of 9%, the actuarial method is probably
preferable.
TAX CALCULATION
R Million 0 1 2 3 4 5 6
Acc Depr. (R12mx20%) (2.4) (2.4) (2.4) (2.4) (2.4) ()
Interest (1.08) (0.91) (0.71) (0.49) (0.26) (CE)
Recoup. / Scrap Allow. (-----)
(3.48) (3.31) (3.11) (2.89) 2.66
Tax at 28% 0.97 0.93 0.87 0.81 0.74
Tax Refund / (Paid) 0.97 0.93 0.87 0.81 0.74

CASH FLOWS
R Million 0 1 2 3 4 6 5
Lease Payments () (3) (3) (3) (3) (3)
Residual -----
Tax (from Calculation) () 0.97 0.93 0.87 0.81 0.74
Total (3) (2.03) (2.07) (2.13) (2.19) 0.74
Discount rate = 5% NPV = (R9.40 Million) (using a financial calculator) ( if correct)
Discount rate = 5.04% NPV = (R9.39 Million) (using a financial calculator)
QUESTION 1 (CONTINUED) [25 marks]
1.2 Discuss the appropriateness of using Advanced Health’s cost of debt to Max
evaluate the financing decision. Marks
 The decision to invest in the laser machine being financed will have
already been evaluated taking project specific risk into account. The
evaluation in 1.1 is being used to support the financing decision rather than ()
the investment decision.
 Cash flows should be discounted at either WACC or the project specific
discount rate when evaluating the investment decision since the project
is financed using the company’s debt and equity resources. ()
 However, the financing decision is a separate decision and the discount
rate should be tailored appropriately. ()
 In the financing decision, we can use debt as the ‘base line’ and compare
other forms of finance to the cost of debt by using the cost of debt as the
discount rate. ()
 The after-tax cost of debt is the opportunity cost of leasing and can be
used to discount the incremental cash flows arising from leasing as ()
compared to buying outright using this discount rate.
 Any other relevant point. ()

(MAX = 4)

1.3 Evaluate the financial and non-financial factors that might affect Advanced Max
Health’s choice of financing between schemes A and B. Marks
Cost
 As seen in 1.1, the borrow and buy scheme is cheaper than the lease on
the basis of the data provided.
 This is largely due to the higher implied interest under the lease of 9%
versus 7% for the bank loan.
 Wear and Tear allowances are also accelerated under the bank loan, Up to
with a 100% deduction available in year 1 rather than spread over the 5 year ()
period as in the lease. This may not be an issue, though, if the lessor can
also claim a 100% deduction in year one and builds this into the price of the
lease rental.
 However, it is not clear whether the cost of debt quoted would apply in this
case. Indeed, Advanced Health may be able to negotiate a lower rate of
interest for a loan secured against an asset. The bank may also charge a
different rate for a fixed rate 5 year loan.

Timing of funding cash flows

 Under the lease, the funding is built into the lease rentals and hence
interest is only charged on the outstanding balance at any point in time.
If a term loan from a bank is for a fixed principal value for the 5 year term, it Up to
will involve higher interest costs than shown in the analysis in 1.1. ()
 An amortising loan may be charged at a higher interest rate. The
evaluation in 1.1 would need to be adjusted to take this into account.
QUESTION 1 (CONTINUED) [25 marks]

1.3 Evaluate the financial and non-financial factors that might affect Advanced Max
Health’s choice of financing between schemes A and B. Marks
Ease of arrangement
 A bank loan secured against the asset could be costly and time
consuming to arrange as the bank assesses the value of the asset.
 In this case, the vendor of the laser machine is offering a finance
package to make their product more attractive to potential purchasers. Up to
It may therefore be quicker and cheaper to arrange a lease than a ()
separate purchase agreement and bank loan in this instance.
 Additional costs of the bank loan option should therefore be built into the
analysis.

Flexibility
 Under the borrow and buy scheme , Advanced Health owns the equipment
outright and therefore has the flexibility to dispose of or upgrade the
equipment to reflect future changes and the needs of the business.
 Such flexibility is unlikely to be provided under the lease arrangement. Up to
However, if the lease arrangement were to include the opportunity to ()
upgrade the equipment, a lease might prove to be more flexible than the
borrow and buy scheme.
 Without knowing the details of the lease arrangement, it is not possible to
draw any firm conclusions on this issue.

Residual value of the equipment

 Under the borrow and buy scheme, Advanced Health may benefit from any
residual value of the equipment at the end of the five years.
 Although expected to be negligible, the equipment may perform better than
expected and have some unexpected residual value at the end of the five Up to
year term. ()
 This would increase the attractiveness of the borrow and buy scheme.

Maintenance
 It is not clear from the information whether the leasing company would be
responsible for the maintenance of the laser machine.
 Given the level of lease rentals it is unlikely that maintenance costs fees
are included, however, it is possible that the leasing company might provide Up to
maintenance at an additional cost, which might be cheaper than Advanced ()
Health’s own cost.
 However, the leasing company may not maintain the asset to the same
standard that Advanced Health would, therefore making the borrow and
buy scheme more attractive.
 Equally it might be that Advanced Health would provide maintenance in both
situations and therefore this would not be a relevant consideration.

 Any other relevant point. Up to

()
(MAX = 9)