Which finance facility is best for us?

What method of finance shall I use?

When businesses calculate the cost of different sources of finance used, a logical relationship should emerge between the cost of the different sources of finance and the risks involved. This article discusses the implications and variations to determine the correct finance facility upon purchasing assets.

This method of determining ones options of finance is akin to a balance sheet whereby it is a snap shot in time of a company’s overall worth and will vary given many factors.

Disclaimer

The calculations below are for indicative purposes only. Current tax rates and capital allowance rates vary and should not be used to alone to determine investment decisions.

Background

XYZ Plc, a coach operator have traded for 125 years. The company are purchasing a new coach to the value of £160,000; before the Finance Director makes a decision on the investment method the company may wish to calculate the NPV (Net Present Value)

(A net present value (NPV) includes all cash flows including initial cash flows such as the cost of purchasing an asset, whereas a present value does not.-we will endeavour to discuss and post full calculations in another article including WACC (weighted average cost of capital and the implications)).

Requirement

Factors that will influence the investment decision for XYZ plc

1. 1. Asset cost (exc VAT): £160,000.00
2. 2. Tax rate: 30% (now 28%-see Fig 1)
3. 3. Capital allowance rate: 25%
4. 4. Months to year end: 6 remaining
5. 5. Opportunity cost of funds: 8.00%
6. 6. Depreciation rate: 6.67% per annum
7. 7. Asset kept for: 180 months

A synopsis of the net present cost, (please see explanation above) after tax over 180 months.

Most beneficial Consideration

Description Net Present Value

Hire Purchase 10 yrs 118102.65

Hire purchase 7 yrs 119706.41

Operating Lease 7 yrs 124458.72

Finance Lease 7 yrs 125634.50

Operating Lease 5 yrs 129528.88

The option with the lowest NPV should be considered the most economical, in this case XYZ plc should consider a Hire Purchase facility over a 10 year period, although many other factors will influence this decision.

*The discount rate is 5.71%

Compounding and discounting

Compounding is the way to determine the future value of a sum of money invested now, for e.g. in a bank account, where interest is left in the account after it has been paid. Since interest received is left in the account, interest is earned on interest in future years; the future value depends on the rate of interest paid, the initial sum invested and the number of years the sum is invested for.

Discounting is the opposite of compounding, compounding takes us forward discounting takes up backwards from the future value of a cash flow to its present value.