Making the correct investment choice
Article by Drew Coles member of the Chartered Institute of Management Accountants
One of the most important decisions companies can make is what capital equipment should be invested in. Because of the high amount of funds invested in these decisions it is critical that an analysis of all possible options is investigated. This article will take you through a few options in the decision-making process.
Lease v buy decision
When purchasing capital equipment there may be an option to lease the asset instead of making a purchase. The benefits of leasing include:-
Reduction in cash outflow. Where as a purchase may require a high cash outflow at the start of the period a lease will require usually a deposit with the rest of payments made monthly over the term of the lease. This can help the company regulate its cash-flow
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Leasing can be cheaper than purchasing the asset outright. This would need to be summarised using the net present cost method.
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Leasing can also be a cheaper form of finance as the loan section of the lease is already secured against the capital equipment.
In terms of purchasing the asset depending on the amount of capital that needs to be invested a loan will probably be required. If the business is to secure a loan, there will probably be charges that need to be placed against business assets. These can be fixed against capital assets for example or floating which can be charged against stock if the loan does not get repaid.
Tax benefits
Lease payments are tax allowable which means you can charge them against the profit for the period enabling you to reduce the tax liability. For tax purposes leases usually follow the legal form meaning capital allowances are not allowed.If the company purchases the asset annual tax investment allowances can be used. This means the business can claim either a large portion of the equipment through annual investment allowances in the year or claim each year by using writing down allowances, both will result in a lower tax liability.
Leasing and purchasing effect on financial statements
Whichever method is chosen each has a different effect on the accounting statements which needs to be considered.Purchasing accounting treatment
If the company is to purchase the asset it will be held on a capital asset register and shown on the statement of financial position (balance sheet) and depreciated annually through the profit and loss. Aspects that need to be forecast are life of the asset, residual value and depreciating method in according with accounting standards.
Leasing accounting treatment
The accounting treatment of leasing will be dependent on the lease being an operating lease or a finance lease. This is accounted for according to the leases commercial substance instead of its legal form. A finance lease is an agreement which transfers commercially all the risks and rewards of ownership to the lessee.
A Finance lease will be split between two parts. The value of the asset or present value of the minimum lease payments (whichever is lower) will be held as a non-current asset on the balance sheet and depreciated through the profit and loss using accounting standards. The Life of the asset for depreciation purposes is normally the term of the lease. The loan will be held under noncurrent liabilities on the balance sheet with the liability being reduced after each payment which will be allocated to the profit and loss under finance charge.
In terms of an operating lease this will be expensed on a straight-line basis to the profit and loss in the actual period it is used.
Tools to use in calculations – Net Present Cost and payback
To calculate which investment and whether to lease or buy there are several tools which should be used to quantify the results. Net present cost is a variation of net present value and is the most reliable and proven to be effective.Net present cost
Net present cost uses discounted cashflows adjusted for inflation and interest to ascertain which investment should be chosen. Cash outflows are deducted from cash inflows to arrive at a present value. Cash-flows are less subjective than profits therefore they are more reliable to base the decision. To calculate using net present cost the savings made form the investment and the total costs of each investment must be known, further only relevant costs should be considered and particularly not sunk costs. We would also need to know an interest rate charged if a loan is used to purchase the capital equipment or the interest rate charged on a lease. Other factors that need to be known are tax savings to calculate each method fully. In most cases the investment with lowest net present cost should be chosen.
Payback
Another tool which should be used is payback period. The payback method calculated the amount of time taken to repay the initial investment in the equipment. It also takes into account risk and therefore is a simple and effective tool to compare investments. The lower the time taken to repay the initial investment the less risk and more likely it should be considered.
Qualitative factors
Qualitative factors are outcomes of the decision taken that cannot be measured but should be taken into consideration. For instance, if new machinery is purchased there may be an improvement in the quality of products produced or there may be a reduction in the number of errors due to some part of production being automated. There could be other factors to consider such as the ability to do different types of work and branch into new industry.Related Artcle
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