To: The Directors of Leaminger plc
From: A business advisor
Date: December 2002
Subject: Acquiring the turbine machine
In financial terms and with no capital rationing the purchasing outright method is the preferred method of financing as it has the lowest negative NPV. With the capital rationing finance lease becomes the preferred method. There are though a number of other factors to be considered before a final decision are taken.
- If capital rationing persevere into further periods the value of cash used in leasing becomes more significant and thus purchasing becomes relatively more attractive.
- Even with no capital rationing leasing has a short-term cash flow advantage over purchasing which may be significant for liquidity.
- The use of a 10% cost of capital possibly inappropriate as these are financing issues and are unlikely to be subject to the average business risk. As well they may alter the capital structure and thus the financial risk of the business and thus the cost of capital itself. This may change the optimal decision in the face of capital rationing.
- The tangible cash inflows generated by the turbine are constant for all options except that under an operating lease the lesser may refuse to lease the turbine at the end of any annual contract thus making it unavailable from this particular source. On top of capital rationing we necessitate to consider the availability of finance as a continuing source under the operating lease.
- Equally though with the operating lease Leaminger plc can cancel if business conditions change (for example a technologically improved asset may become available). This isn't the case with the other options. On the other side if the market is buoyant then the lesser may raise lease rentals whereas the cost is fixed under the other options and hence capital rationing might be more severe.
- On the issue of continuation costs of $15000 per annum this is incorporated in the operating lease if the machine becomes unreliable but there is greater risk beyond any warranty period under the other two options.
- It is value investigating if some interim measure are able to be put in place which would assist in lengthening the turbine's life such as sub-contracting work outside or else overhauling the machine.