Skip to content
Sign inRegister

Ask the Tutor ACCA FM

Kaplan TYU 2 Chapter 5 Lease and Buy

SASayeda Amal9d ago

Hello,

I had a doubt related to this question from Kaplan textbook TYU2 Chapter 5.

  1. While I was practicing I had trouble understanding why the tax relief on capital allowances starts at Time 2 on the Purchase option and not on Time 1.

While going through the OT lecture on Lease and Buy, it started on Time 1.

I'm unable to understand where I might be going wrong.

Also

  1. In the textbook, it says we don't calculate tax relief in the year of disposal. But in the OT notes the question said that the machine was needed for 4 years and "after" 4 years the scrap value is $10,000. So that's why in the 5th year we calculated tax saving on the balancing allowance.

But in the Kaplan question it says the economic useful life is 5 years. So I got a bit confused because in the answer tax saving on depreciation was not calculated for 5th year but rather on balancing allowance which I thought it was supposed to be in Year 6.

Sir I need your help. :)

Lease part is clear for me. It's only the buying part that got me confused.

Thank you so much Sir.

(a)

A firm has decided to acquire a new machine to neutralise the toxic waste produced by its refining plant.

The machine would cost £6.4 million and would have an economic life of five years.

Writing down allowances (WDAs) of 25% per annum, on a reducing balance basis, are available for the investment. Taxation of 30% is payable on operating cash flows, one year in arrears.

The firm intends to finance the new plant by means of a five-year fixed interest loan, at a pre-tax cost of 11.4% pa, principal repayable in five years' time.

As an alternative, a leasing company has proposed a finance lease over five years at £1.42 million per annum, payable in advance.

The scrap value of the machine under each financing alternative will be zero.

IAW3005IAW3005Tutor8d ago#1

In the context of capital allowances and tax relief, the timing of tax relief can indeed cause confusion. Tax relief on capital allowances is generally calculated based on the timing of the asset's purchase.

When a machine is purchased on the last day of an accounting year (time 0), capital allowances are calculated immediately, and the tax effect is realised one year later (t=1 for the first allowance). This is why you may see tax relief starting at time 1 in some scenarios.

However, if the asset is purchased at the beginning of the financial year, the capital allowances would be calculated at the end of that year, and the tax relief would also be recognised one year later, which could lead to a situation where it appears that tax relief starts at time 2.

Regarding the disposal of the asset, the tax relief on capital allowances is not calculated in the year of disposal. Instead, any remaining balance after the sale proceeds is treated as a balancing allowance or charge, which is then eligible for tax relief in the following year. In your example, if the economic life of the machine is five years, the balancing allowance would be calculated in year 5, and the tax relief on that would be realised in year 6.

So it can vary based on when the asset is purchased and the year of disposal.

SASayeda Amal8d ago#2

Thank you for replying. Actually I have an exam in one month's time.

I have understood the concept.

So we have to assume that the asset was bought at the beginning of the year.

That's why in total it's 2 years. And we calculate the tax relief from T2 then.

Also I had another question related to the question in OT notes lease and buy example 3. Why do we not include scrap value in the calculation of NPV just like we do in other questions?

Thank you once again. :)

IAW3005IAW3005Tutor5d ago#3

Lease-or-buy evaluations isolate only the incremental cash flows unique to the financing method (the lease rentals, initial purchase cost, tax savings on capital allowances)

So If the scrap value of the machine does not change between the alternatives being compared, it can be excluded from a cost-comparison

SASayeda Amal2d ago#4

Oh okay. So that's the reason why it's not included. I was going mad searching the textbook trying to find what might be the reason.

Thank you so much. Now it's much clearer.

IAW3005IAW3005Tutor1d ago#5

You are most welcome

Sign into reply to this topic.