ABC Wines Company is considering the acquisition of a new irrigation system for its extensive vineyards. The system could either be bought outright for £10 million or via a finance lease requiring three annual payments in advance of £3.7 million. The leasing company is not the supplier or manufacturer of the equipment.

The new system is expected to give the following pre-tax net cash savings over the existing system in use:
Year Pre-tax net cash savings
1 £6 million
2 £5 million
3 £3 million

The system would require replacement in three years' time and have no residual value. The outright purchase would be financed by a loan with an interest rate of 8%.

Assume that corporation tax is charged at 25% and is payable one year in arrears. Writing down allowances is available on the depreciation of the equipment. The company uses the reducing balance method for depreciation at 25%. Lease payments are allowable for tax in full.

The company has no gearing at present and a cost of capital of 13%.

Complete the following:

1. Evaluate whether ABC Wines should go ahead with the installation of the new irrigation system and whether they should use the purchase or the lease option. (Tip: You should use NPV to perform the analysis; writing down allowances should be taken into consideration.)

2. Explain the primary ways in which finance leases differ from operating leases.