Reference no: EM132611682

Second Ltd. is considering the purchase of a new train to operate a rail contract it has recently bid for and won. A new train will cost £10,000,000. The train is expected to have a working life of six years, which is equal to the life of the contract bid on, and at the end of the contract it is anticipated that it will have no resale value. The capital allowance for the train for tax purposes is a 25 per cent writing down allowance, with the residual value being written off at the end of year six.

The train can also be acquired on the basis of a finance lease. The lease would require an immediate payment of £2,500,000 and six additional lease payments of the same amount at the start of the year over the life of the contract. The company's finance director contends that leasing will allow the company to obtain the maximum benefit from the investment - the net cash flows operating one train will be more than adequate to cover the lease payments and the need to invest in the train is eliminated.

The company requires a rate of return of 12 per cent on this type of investment, but its borrowing rate is 6 per cent. The tax rate is 30 per cent and tax is paid immediately as it arises.

Question a) Evaluate the lease from the position of the company.