Pemberton Engineering: Purchase versus Lease with Capital Allowances
Pemberton Engineering Ltd is deciding whether to purchase or lease a computer-controlled milling machine. The machine costs £1.2 million and would reduce annual operating costs by £420,000 before tax for five years. If purchased, the machine would be sold at the end of year 5 for an estimated £200,000. Tax depreciation is available at 25% reducing balance, with a balancing allowance or charge on disposal. Alternatively, Pemberton can lease the machine for five annual payments of £290,000, payable at the end of each year. Lease payments are fully tax-deductible. The company pays corporation tax at 25%, and tax is paid in the same year as the cash flow. Pemberton’s after-tax cost of capital is 8%. The finance director favours leasing because it keeps debt off the balance sheet and avoids residual value risk, but the operations director argues that ownership gives control over maintenance schedules. The machine is expected to become obsolete within six years.
1. Calculate the NPV of the purchase and lease alternatives, and recommend which should be chosen on financial grounds.
Read the worked answer
Purchase option
| Year | Operating saving £ | Tax saving £ | Residual £ | Net cash flow £ | DF 8% | PV £ |
|---|---|---|---|---|---|---|
| 0 | - | - | - | (1,200,000) | 1.0000 | (1,200,000) |
| 1 | 420,000 | 75,000 | - | 495,000 | 0.9259 | 458,321 |
| 2 | 420,000 | 56,250 | - | 476,250 | 0.8573 | 408,290 |
| 3 | 420,000 | 42,188 | - | 462,188 | 0.7938 | 366,884 |
| 4 | 420,000 | 31,641 | - | 451,641 | 0.7350 | 331,956 |
| 5 | 420,000 | 44,922 | 200,000 | 664,922 | 0.6806 | 452,546 |
NPV = £2,017,997 - £1,200,000 = £817,997, say £818,000.
Tax allowances: 25% reducing balance gives 300,000, 225,000, 168,750, 126,563; disposal for £200,000 gives a balancing allowance of £179,688 in year 5.
Lease option
Net annual cash flow = £420,000 - £290,000 + (25% × £290,000) = £202,500. PV = £202,500 × 3.9927 = £808,522.
Recommendation
Purchase has the higher NPV by about £9,500, but the difference is less than 1.2% of the lease NPV. On financial grounds the decision is marginal; purchase is slightly preferred, but the company should treat the result as sensitive to the residual value, tax rate and discount rate.
2. Discuss the non-financial and tax-risk factors that could change the recommendation, including deferred tax.
Read the worked answer
Non-financial factors
- Residual value risk: the £200,000 disposal value is an estimate; a lower value reduces the purchase NPV. A sensitivity of £50,000 changes NPV by £34,030 at the 8% factor.
- Obsolescence: the machine may be obsolete within six years, so a five-year ownership period is already tight. Leasing shifts technological risk to the lessor.
- Maintenance and control: ownership gives control over maintenance and production scheduling; leasing may include maintenance and upgrade options.
- Flexibility: leasing preserves capacity flexibility if demand falls.
Tax and accounting risks
- The ‘off-balance-sheet’ argument is weak under IFRS 16: a lease creates a right-of-use asset and a lease liability, so it affects gearing and covenants.
- Deferred tax: purchase creates a temporary difference between the carrying amount of the machine and its tax base. As capital allowances accelerate, a deferred tax liability may arise and then reverse.
- Tax rate changes: if the tax rate falls, the value of capital allowances and lease deductions falls; the timing of the change matters.
- Lease classification and tax deductibility should be confirmed with tax advisers.
Overall, purchase is slightly better financially, but the board should negotiate lease terms and obtain a binding residual value estimate before deciding.