107475 1139083 Chapter 9 Lease Decisions

J B GUPTA CLASSES 98184931932, [email protected],

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Copyright: Dr JB Gupta

Chapter 9Chapter 9Chapter 9Chapter 9 Lease DecisionsLease DecisionsLease DecisionsLease Decisions

Chapter IndexChapter IndexChapter IndexChapter Index

� Three Methods of Lease V/S Purchase Evaluation

� Calculation of Lease Rent – 4 Situations

� Lease V/S Hire Purchase

� Monthly Lease Installments

� Calculation of Cost of the Machine

� Cross – Border Lease

� Extra Practice (Must Do)

� Extra Practice (Optional)

� Theoretical Aspects

(i) Financial Lease v/s Operating Lease

(ii) Advantages of Lease Fancying

(iii) IRR Method of Lease Evaluation

(iv) Cross-Border Lease

There are three methods of lease decisions :

(i) NPV : Find NPV by the method discussed in capital budgeting chapter. If

the question is silent about loan repayment including interest, it may be

assumed that loan will be repaid including interest in the same period as

the term of lease. This assumption places loan on an equivalent basis with

lease.

(ii) Cost of Lease by IRR Method: Find incremental cash flows of lease assuming purchase

with the help of own funds. Find cost of lease by IIRR Method.

(iii) Williomson Method (B.S.W. Method) Under this method, we find operating

result and financial result. Tax is totally ignored for calculating financial

result. Financial result in “PV of loan repayments including interest – PV

of lease payment”. Operating result is PV of “Tax saving in case of lease

– tax saving in case of purchase”. Find sum of both results. If the sum is

2

positive, lease is preferred. If sum is zero, the decision is taken on the

basis of non-financial considerations. If the sum is negative, purchase is

preferred.

Lease v/s buy decision: The key issue in lease v/s buy decision is the appropriate

discount rate. In this connection there are two views :

(i) We have to decide regarding acquiring a fixed asset. We use the capital

budgeting technique. Hence, the appropriate discounting rate is cost of

capital.

(ii) The other view is quite different. A lease versus buy analysis is

performed when the decision is made to acquire an asset. “It is not a

capital expenditure decision. It is financing decision. Whether nor not to

acquire the asset is not part of typical lease analysis – in a lease

analysis we are simply concerned with whether to obtain the use of the

asset through lease or by purchase.1” Rather we can say the analysis

does not aim to decide lease or purchase (as the purchase has already

been decided); it is to decided whether lease or borrow. The cash flows

of this analysis are more like debt service cash flows than operating

cash flows2. Hence the appropriate discount rate is the after tax cost of

debt.

The second view seems to be more appropriate.

[The students are advised to follow the second view except in the following cases:

(i) We are given discount rate in the question, we should discount the cash

flows at the given discount rate ( For example Question No.19, please the

first sentence of the question) (ii) Post – tax cost of debt is neither given in

the question nor it can be calculated ( for example : Questions No.10,33) and

(iii) We are given the present value factors (PVFs) in the question and these

are not of “post –tax cost of debt”. (For example : Question No.18) We should

discount the cash flows on the basis of these PVFs.]

The above-mentioned difference of opinion does not apply to decision from lessor

point of view. From the lessor point of view, the lease analysis is a capital

expenditure decision (capital budgeting decision). Hence, the appropriate

discount rate is the cost of capital of the firm.

THREE METHODS OF LEASE V/S PURCHASE EVALUATIONTHREE METHODS OF LEASE V/S PURCHASE EVALUATIONTHREE METHODS OF LEASE V/S PURCHASE EVALUATIONTHREE METHODS OF LEASE V/S PURCHASE EVALUATION

Q. No. 1: Q. No. 1: Q. No. 1: Q. No. 1: An industrial unit desires to acquire a machine costing Rs.5 Lakh which has

an economic life of 10 years, scrap value nil. The unit is considering the alternative

choice of:

1 Financial Management – Brigham and Ehrhardt.

2 There is almost no uncertainty in debt –service like cash flows as the cash flows are governed by

the contracts. The operating cash flows are estimated ones, these are not contractual, hence these

are uncertain.

3

(a) Taking machine on lease of

(b) Purchasing the asset by raising loan.

Lease payments are to be made in advance and the lessor requires the asset to the

completely amortized over its useful life and that the asset will yield him a return of 10 per

cent.

Rate of interest is 16 per cent p.a. Tax 50 per cent. Straight line method of

depreciation may be adopted. Evaluate the proposal by all three methods of

evaluation of lease v/s buy. (May, 1984)(May, 1984)(May, 1984)(May, 1984)

AnswerAnswerAnswerAnswer

Working Notes 1

Annual lease rent = 5,00,000 × ———— = 73976

1 + 5.759

Tax savings on annual lease rent = 36,988

1 3Annual payment to bank= 5,00,000 × ————--- = 89,174 1 + 4.607

Table showing interest in various bank payments:

Amt. Due Principal Interest Tax Saving of Interest. I 5,00,000

89,174 89,174 — —

II 4,10,826

23,442 23,442 65,732 32,866

III 3,87,384

27,193 27,193 61,981 30,991

IV 3,60,191

31,543 31,543 57,631 28,816

V 3,28,648

36,590 36,590 52,584 26,292

VI 2,92,058

42,444 42,444 46,730 23,365

VII 2,49,614

49,236 49,236 39,938 19,969

VIII 2,00,378

57,113 57,113 32,061 16,031

IX 1,43,265

66,252 66,252 22,922 11,461

3 As the question is silent about the schedule of loan repayment including interest, it has been

assumed that loan will be repaid including interest in the same period as the term of lease. This

assumption places loan on an equivalent basis with lease.

4

X 77,013

77,013 77,013 12,161 6,081

NPV METHODNPV METHODNPV METHODNPV METHOD

DCF ANALYSIS OF LEASDCF ANALYSIS OF LEASDCF ANALYSIS OF LEASDCF ANALYSIS OF LEASE PROPOSAL E PROPOSAL E PROPOSAL E PROPOSAL

PERIIOD PVF/A CASHFLOW PV

Lease rent 0-9 7.247 -73976 annually -5,36,104

Tax savings 1-10 6.710 +36988 annually +2,48,189

-2,87,915

DCF ANALYSIS OF PURCDCF ANALYSIS OF PURCDCF ANALYSIS OF PURCDCF ANALYSIS OF PURCHASE PROPOSAL HASE PROPOSAL HASE PROPOSAL HASE PROPOSAL


Bank payments 0-9 7.247 -89,17489,17489,17489,174 annually -6,46,244

Tax savings 1 0.926 +57,866 +53,584

2 0.857 +55,911 +47,916

3 0.794 +53,816 +42,730

4 0.735 +51,292 +37,700

5 0.681 +48,365 +32,937

6 0.630 +44,969 +28,330

7 0.583 +41,031 +23,921

8 0.540 +36,461 +19,689

9 0.500 +31,081 +15,541

10 0.463 +25,000 +11,575

-332321

Lease is recommended on account of its lower net present value of cost.

TeachinTeachinTeachinTeachingggg note:note:note:note: not to be given in the exam: the interest included in 2nd payment

will be allowed as deduction for income tax purposes against I year’s taxable

income. It is the interest for the first year and it is being paid before the last date

of submitting the Income Tax return.

Similarly, the interest included in 3rd payment will be allowed as deduction for

income tax purposes against the II year’s taxable income.

And so on.

[Section 43(b) of Income tax Act,1961]

5

COST OF LEASE METHODCOST OF LEASE METHODCOST OF LEASE METHODCOST OF LEASE METHOD

(ALSO KNOWN AS IRR M(ALSO KNOWN AS IRR M(ALSO KNOWN AS IRR M(ALSO KNOWN AS IRR METHOD OF LEASE EVALUETHOD OF LEASE EVALUETHOD OF LEASE EVALUETHOD OF LEASE EVALUATIONATIONATIONATION)

INCRREMENTAL CASHFLOWS

PERIIOD LEASE PURCHASE INCREMENTAL CASHFLOW

0 -73,976 -5,00,000 +4,26,024

1 -36,988 +25,000 -61988

2 -36,988 +25,000 -61988

3 -36,988 +25,000 -61988

4 -36,988 +25,000 -61988

5 -36,988 +25,000 -61988

6 -36,988 +25,000 -61988

7 -36,988 +25,000 -61988

8 -36,988 +25,000 -61988

9 -36,988 +25,000 -61988

10 +36,988 +25,000 +11988

FAKE PAYBACK PERIOD = 4,26,024/61988 = 6.87

Consulting the annuity table, approximate rate = 6%

NPV at 6%

+426024

-61988x6.802

+11988x0.558

= +11,071

NPV at 4%

+426024

-61988x7.435

+11988x0.676

= -26753

Cost of Lease :

-26,753

= 4 + ---------------------------x 2 = 5.42 %

-26753 – 11071

Cost of lease = 5.42%

Cost of borrowing = 8%. Lease is recommended.

WILLIOMSON METHODWILLIOMSON METHODWILLIOMSON METHODWILLIOMSON METHOD (B.S.W METHOD)(B.S.W METHOD)(B.S.W METHOD)(B.S.W METHOD)

Financial result = 89,174 (1 + 4.607) – 73,976 (1 + 4.607) = + 85,217.

6

Computation of operating result:

Year Tax Saving Tax Saving Net Tax P.V. (8%) (Lease) (Purchase) Savings 1. 36,988 25,000 + 32,866 – 20,878 – 19,333

2. 36,988 25,000 + 30,911 – 19,003 – 16,286

3. 36,988 25,000 + 28,816 – 16,828 – 13,361

4. 36,988 25,000 + 26,292 – 14,304 – 10,513

5. 36,988 25,000 + 23,365 – 11,377 – 7,748

6. 36,988 25,000 + 19,969 – 7,981 – 5,028

7. 36,988 25,000 + 16,031 – 4,042 – 2,154

8. 36,988 25,000 + 11,461 527 + 285

9. 36,988 25,000 + 6,081 5,907 + 2,954

10. 36,988 25,000 + 0 11,988 + 5,550 —————

– 65,634

Total Result = 85,217 + (– 65,634) = 19,583

As total result is positive, lease may be preferred.

CALCULATION OF LEASE RENT CALCULATION OF LEASE RENT CALCULATION OF LEASE RENT CALCULATION OF LEASE RENT –––– 4 SITUATIONS4 SITUATIONS4 SITUATIONS4 SITUATIONS

I.I.I.I. Calculation of lease rent which matches with purchase/loan option : Assume

lease rental to be x. Equate “ present value of purchase/loan option” with

“present value of lease option (based on lease rent x )”. Find the value of x.

This is referred as break-even lease rental.

Example : Example : Example : Example : Q. No. 2, 3

II.II.II.II. Calculating equal lease rent to provide pre tax return to lessor:

Lease rent = Apply IRR method ( ignore the tax of Lessor)

Example:Example:Example:Example: Q. No. 1.

III. III. III. III. Calculating unequal lease rent to provide pre tax return to lessor:

Apply IRR method. Example:Example:Example:Example: Q. No. 4. ( ignore the tax of Lessor)

IV. IV. IV. IV. Calculating lease rent to provide post tax return to the lessor.

Apply IRR method.

Example :Example :Example :Example : Q. No. 5,6 (iii) ( consider the tax of Lessor)

TEACHING NOTETEACHING NOTETEACHING NOTETEACHING NOTE: Before calculating lease rent, we should find whether we have

to calculate lease rent from lessee point of view or lessor point of view.

If the question is silent on the point whether we have to calculate pre-tax or post

tax lease rent:

(i) Calculate pre-tax lease rent if we have to take the decision from

lessee point of view ( calculate lease rent ignoring tax)

(ii) Calculate post-tax lease rent if we have to take the decision from lessor

7

point of view.

If the question has some specific requirement regarding pre-tax or post-tax lease

rent, we should follow that instruction.

Q .No. 2: Q .No. 2: Q .No. 2: Q .No. 2: Beta Limited is considering the acquisition of a personal computer costing

Rs. 50,000. The effective life of the computer is expected to be five years. The

company plans to acquire the same either by borrowing Rs. 50,000 from its bankers

at 15 per cent interest per annum or by lease. The company wishes to know the

lease rentals to be paid annually which will match the loan option. The following

further information is provided to you:

(a) The principal amount of the loan will be paid in five annual equal installments.

(b) Interest, lease rental, principal repayment are to be paid on the last day of each

year.

(c) The full cost of the computer will be written off over the effective life of

computer on a straight line basis and the same will be allowed for tax purposes.

(d) The company’s effective tax rate is 40 per cent and the after tax cost of capital

is 9 per cent.

(e) The computer will be sold for Rs.1,700 at the end of the fifth year. The

commission on such sales is 9 per cent on the sale value and the same will be

paid.

Compute the annual lease rental payable by Beta Limited which will result in

indifference to the loan option. Discount factors: .92, .84, .77, .71, .65.

Answer:Answer:Answer:Answer:

Borrow Rs.50,000 from bank

Period Loan

repayment

Interest Tax Saving on Interest

& Depreciation

CF

1 10000 7500 7000 10500

2 10000 6000 6400 9600

3 10000 4500 5800 8700

4 10000 3000 5200 7800

5 10000 1500 4600 6900

Period 5 : sale of scrap net of com. and tax = 1700x.91x.60 = Rs.928

Present value of cost under purchase proposal:

Period PV of cost

1 10500x0.92

2 9600x0.84

3 8700x0.77

4 7800x0.71

5 6900x.0.65

5 -928x0.65

33,843

8

Let equal. Lease rent (annual) =X

(0.60X)(3.89) = 33843 X = 14500

Hence annual lease rent (equal. To purchase proposal) = Rs.14500

TEACHING NOTETEACHING NOTETEACHING NOTETEACHING NOTE – not to be given in the exam: Cost Rs.50,000. Depreciation

claimed in 5 years Rs.50,000 (because the question says that the full cost of the

computer will be written off over the effective life of computer on a straight line

basis).

WDV = Nil

Net sale value of scrap = 1,700 x 0.91 = 1547

STCG = 1547

( The capital gain / loss on the depreciable asset is treated as STC gain/ STC loss

for Income tax purposes)

Tax on STCG = 619

Net realization = 1547 – 619 = Rs.928

Q. No.3Q. No.3Q. No.3Q. No.3:::: Welsh Limited is faced with a decision to purchase or acquire on lease a

mini car. The cost of mini car is Rs.1,26,965. It has a life of 5 years. The mini car

can be obtained on lease by paying equal lease rentals annually. The leasing

company desires a return of 10 per cent on the gross value of the asset. Welsh

Limited can also obtain 100 per cent finance from its regular banking channel. The

rate of interest will be 15 per cent p.a. and the loan will be paid in five annual equal

installments, inclusive of interest. The effective tax rate of the company is 40 per

cent. For the purpose of taxation it is to be assumed that the asset will be written off

over a period of 5 years on a straight line basis.

(a) Advise Welsh Limited about the method of acquiring the car.

(b) What should be the annual lease rental to be charged by the leasing company to

match the loan option? ((((May 1996May 1996May 1996May 1996)))) (20 Marks)

Answer :Answer :Answer :Answer :

(a)Working notes :(a)Working notes :(a)Working notes :(a)Working notes :

Assumption :lease rent is payable in the beginning of the year.

Annual lease rent = ( 1,26,965 ) / ( 1 + 3.17 ) = 30,447

4Loan installment = ( 1,26,965 ) / ( 1 + 2.855) = 32,935

4 As the question is silent about the schedule of loan repayment including interest, it has been

assumed that loan will be repaid including interest in the same period as the term of lease. This

assumption places loan on an equivalent basis with lease.

9

CaCaCaCalculation of interest lculation of interest lculation of interest lculation of interest : : : :

Amount due Principal Interest

Total borrowing

I Payment

II Payment

III Payment

IV Payment

V payment

1,26,965

32,935

94,030

18,830

75,200

21,655

53,545

24,903

28,642

28,642

32,935

18,830

21,655

24,903

28,642

Nil

14,105

11,280

8,032

4,293

Year Dep. Dep. + int. Tax savings PV

1 25393 39498 15799 14488

2 25393 36673 14669 12351

3 25393 33425 13370 10322

4 25393 29686 11874 8407

5 25393 10157 6602

DCF ANALYSIS OF PURCDCF ANALYSIS OF PURCDCF ANALYSIS OF PURCDCF ANALYSIS OF PURCHASE PROPOSAL HASE PROPOSAL HASE PROPOSAL HASE PROPOSAL


Bank payments 0-4 4.24 -32,935 -1,39,644

Tax savings +52,170

NPV OF COST -87474



Lease rent 0-4 4.24 -30,447 Annually -1,29,095

Tax savings 1-5 3.89 +12,179

Annually

+47,376

NPV OF COST -81,719


Answer (b) Answer (b) Answer (b) Answer (b)

Let the required lease rent = y

10

-87474 = -y(4.24) + 0.40y(3.89)

-2.684y = -87474

y = 32591

Annual lease rent (payable in the beginning of each year) = Rs.32,591

Q. No. 4: Q. No. 4: Q. No. 4: Q. No. 4: X Ltd is to acquire a machine, costing Rs.1,00,000 on 5 years lease.

Calculate annual lease rent if the lessor expects pre-tax return of 10% and the lease

rents are to be in the ratio of 1:2:3:4:5 for 1st , 2nd,….. 5th year respectively.


Assumption: Lease rent is to be paid in the beginning of the year.

Let annual lease rent = y

0 = - 1,00,000 + y + 2.y.(0.909) + 3.y.(0.826) +4.y.(0.751) + 5.y.(0.683)

- 11.715.y = -1,00,000

y =8,536

Year Lease rent payable in the beginning of the year

1 Rs. 8,536

2 Rs.17,072

3 Rs.25,608

4 Rs.34,144

5 Rs.42,680

Q. No.5: Q. No.5: Q. No.5: Q. No.5: Fair Finance, a leasing company, has been approached by a prospective

customer intending to acquire a machine whose cash down price is Rs.3 Crores.

The customer, in order to leverage his tax position, has requested a quote for a

three year lease rentals payable at the end of each year but in a diminishing manner

such that they are in the ratio of 3:2:1. Depreciation can be assumed to be on

straight line basis and Fair Finance’s marginal tax rate is 35%. The target rate of

return for Fair Finance on the transaction is 10%. Calculate the lease rents to be

quoted for the lease for three years. (Nov. 2004)(Nov. 2004)(Nov. 2004)(Nov. 2004)

Answer:Answer:Answer:Answer: Let lease rent of first year = 3x

Year PV of cash inflow

1 [(3x) – (3x – 1,00,00,000)(.35)] x 0.909

2 [(2x) – (2x – 1,00,000,00)(.35)] x 0.826

3 [(x) – (x – 1,00,00,000)(.35)] x 0.751

Total 3.3345x + 87,01,000

- 3,00,00,000 + 3.3345x + 87,01,000 = 0

x = 63,87,464

Lease rent for 1st year : 1,91,62,392

Lease rent for 2nd year : 1,27,74,928

Lease rent for 3rd year : 63,87,464

Q. No. 6 Q. No. 6 Q. No. 6 Q. No. 6 : Armada Leasing Company is considering a proposal to lease out a school

bus. The bus can be purchased for Rs.5,00,000 and , in turn, be leased out at

11

Rs.1,25,000 per year for 8 years with payments occurring at the end of each

year:

(i) Estimate the internal rate of return for the company assuming tax is ignored

(ii) what should be the yearly lease payment charged by the company in order to

earn 20% annual compounded rate of return before expenses and taxes?

(iii) calculate the annual lease rent to be charged so as to amount to 20% after

tax annual compound rate of return, based on the following assumptions: (a)

tax rate 40 % ,Straight line depreciation (b) annual expenses of Rs.50,000 and

(c) resale value of Rs.100000 after the term. (May, 2003)(May, 2003)(May, 2003)(May, 2003)


(i) Pay back period = 5.00.000 / 125000 = 4

Approx. IRR = 19 %

NPV at 19 % = (-500000) + (125000 x 3.954 ) = -5750

NPV at 18 % = (-500000) + (125000 x 4.078 ) = 9750

9750

IRR = 18 + ------------------------ x 1 = 18.6290

9750 – (-5750)

(ii) Assumption: lease rent is payable at year end

Annual lease rent: 5,00,000 / 3.837 = 1,30,310

(iii) Assumption: lease rent is payable at year end

Let annual lease rent = x

[(x) – ( 50,000) – (x-50,000-50,000)(.40)] x 3.837

+ (100000) x (0.233) - 5,00,000 = 0

x = 2,23,730

Q. No. 7:Q. No. 7:Q. No. 7:Q. No. 7: ABC Ltd. is considering a proposal to acquire a machine costing

Rs.1,10,000 payable Rs.10,000 down and balance payable in 10 annual equal

installments at the end of each year inclusive of interest chargeable at 15%.

Another option before it is to acquire the asset on a lease rental of Rs.15,000 per

annum payable at the end of each year for 10 years. The following information is

available :

(i) Terminal scrap value of Rs.20,000 is realizable , if the asset is purchased.

(ii) the company provides 10% depreciation on straight line on the original cost

(iii) Income rate is 50%

You are required to compute and analyze cash flows and to advise as to which

option is better. (May, 2005)(May, 2005)(May, 2005)(May, 2005)

12


Purchase option : Annual installment : 100000 /5.0188 = 19925

Amount Due Principal Interest

1,10,000

Down payment -10000 10000 Nil

Balance Due 1,00,000

I Installment -4925 4925 15000

Balance Due 95,075

II Installment -5,664 5664 14261

Balance Due 89,411

III installment -6,513 6513 13412

Balance Due 82,898

IV installment -7,490 7490 12435

Balance Due 75,408

V installment -8,614 8614 11,311

Balance Due 66,794

VI Installment -9,906 9906 10019

Balance Due 56,888

VII installment -11,392 11,392 8533

Balance Due 45,496

VIII installment -13,101 13,101 6,824

Balance Due 32,395

IX Installment -15,066 15066 4859

Balance Due 17,329

X Installment -17,329 17329 2596

Balance Due nil

PV of tax savings on interest and depreciation

Year Int. and

depreciation

Tax saving on int.

and Depreciation

PVF PV

1 26000 13000 .930 12090

2 25261 12631 .865 10926

3 24412 12206 .805 9826

4 23435 11718 .748 8765

5 22311 11156 .696 7765

6 21019 10510 .647 6800

7 19533 9767 .602 5880

8 17824 8912 .560 4991

9 15859 7930 .521 4132

10 13596 6798 .484 3290

13

Total 6.858 74465

NPV of purchase proposal:

Period PV

Payment to Bank 0 -10,000

----do------- 1-10 -19925 x 6.858

Tax saving on

depreciation and interest

+74465

Sale of scrap net of tax 10 +10,000 x 0.484

NPV of cost under purchase proposal -67,341

NPV of cost under lease = -7,500 x 6.858 -51,435

Lease is recommended.

Q. No. 8:Q. No. 8:Q. No. 8:Q. No. 8: ABC Ltd sells computer services to its clients. The company has recently

completed a feasibility study and decided to acquire an additional computer, the

details of which are as follows:

(i) The purchase price of the computer is Rs.2,30,000; maintenance, property taxes

and insurance will be Rs.20,000 per year. The additional expenses to operate the

computer are estimated to be Rs.80,000. If the computer is rented from the owner,

the annual rent will be Rs.85,000, plus 5% of the annual billings. The rent is due on

the last day of each year.

(ii) Due to competitive conditions, the company feels that it will be necessary to

replace the computer at the end of three years with a more advanced model. Its

resale value is estimated at Rs.1,10,000.

(iii) Tax rate 50%. Depreciation method: straight line.

(iv) The annual billing will be Rs.2,20,000 in the first year and Rs.2,60,000 annually

for next two years

(v) if the computer is purchased, the company will borrow to finance the purchase

from a bank with interest at 16% p.a. the interest will be paid regularly and the

principal will be returned in lump sum at the end of year 3.

Should the company purchase the computer or lease it? Assume (i) cost of capital as

12%, (ii) straight line depreciation (iii) Salvage value Rs.1,10,000 and evaluate the

proposal from the point of view of lessor also. (Nov. 2007)(Nov. 2007)(Nov. 2007)(Nov. 2007)


Assumptions:

(i) The lessor’s cost of capital is 12%.

(ii) (a)The maintenance, property taxes and insurance Rs. 20,000 per year

and (b) operating expenses of Rs, 80,000 per year will be born by ABC

Ltd in case of lease as well as purchase.

Decision from lessee point of view (Rs.’000)

14

DCF analysis of Lease Proposal

Year 1 Year 2 Year 3 Total

Payment to lessor 85 + 11 85 + 13 85+13

Tax savings 48 49 49

Net cash outflow 48 49 49

PV 0.926 x48 0,857 x 49 0.794 x 49 125.35


Payment to bank 36.80 36.80 266.80

Tax saving on dep.& int. 38.40 38.40 38.40

Sale of scrap - - 110

Net cash flow +1.60 +1.60 -118.40

PV +1.60 x 0.926 +1.60 x 0.857 -118.40 x 0.794 91.16

Buying is recommended on account of its lower net present value of cost.

Analysis of the proposal from lessor point of view Analysis of the proposal from lessor point of view Analysis of the proposal from lessor point of view Analysis of the proposal from lessor point of view :

Working note (Rs.Thousands)

Year Lease rent +

revenue share

Depreciation Tax Cash flow

1 96 40 28 68

2 98 40 29 69

3 98 40 29 69

NPV (Rs.’000) = - 230 + 68.(0.893) + 69.(0.797) +179.(0.712) = 13.165

Lease proposal is profitable from the lessor point of view.

Q. No. 9:Q. No. 9:Q. No. 9:Q. No. 9: Agrani Ltd. is in the business of manufacturing bearings. Some more

product lines are being planned to be added to the existing system. The machinery

required may be bought or may be taken on lease. The cost of machine is

Rs.40,00,000 having a useful life of 5 years with the salvage value of Rs.8,00,000.

The full purchase value of machine can be financed by 20 per cent loan repayable in

five equal installments falling due at the end of each year. Alternatively, the machine

can be procured on a 5 years lease, year-end lease rentals being Rs. 12,00,000 per

annum. The company follows the written down value method of depreciation at the

rate of 25 per cent. Company’s tax rate is 35 per cent and cost of capital is 14 per

cent:

(i) Advise the company which option it should choose – lease or borrow.

(ii) Assess the proposal from the lessor’s point of view examining whether leasing

the machine is financially viable at 14 per cent cost of capital (Detailed working

notes should be given. Calculations can be rounded off to Rs. lakhs. ((((Nov. 2002Nov. 2002Nov. 2002Nov. 2002))))

15

Working note :Working note :Working note :Working note :


Loan installment = ( 40,00,000 ) / ( 2.991 ) = 13,37,345

Calculation of interest and tax savings of interest: Calculation of interest and tax savings of interest: Calculation of interest and tax savings of interest: Calculation of interest and tax savings of interest:

Amount due Principal Interest Tax saving of interest

Total borrowing

I Payment

II Payment

III Payment

IV Payment

V payment

40,00,000

5,37,345

34,62,655

6,44,814

28,17,841

7,73,777

20,44,064

9,28,532

11,15,532

11,15,532

5,37,345

6,44,814

7,73,777

9,28,532

11,15,532

8,00,000

6,92,531

5,63,568

4,08,813

2,21,813

2,80,000

2,42,386

1,97,249

1,43,085

77,635

YEAR DEP/STCL WDV

1 10,00,000 30,00,000

2 7, 50,000 22,50,000

3 5,62,500 16,87,500

4 4,21,875 12,65,625

5 4,65,625 (STCL)

Assumption: In future year 5, the company shall have sufficient amount of STCG to

take tax advantage, by way of set off, of STCL arising in that year.

Tax savings on Depreciation / STCL :Tax savings on Depreciation / STCL :Tax savings on Depreciation / STCL :Tax savings on Depreciation / STCL :

Year 1: 3,50,000 Year 2: 2,62,500

Year 3:1,96,875 Year 4: 1,47,656

Year 5: 1,62,969

Year Loan

installment

Tax savings on Interest

& Depreciation / STCL

CF

1 1337345 630000 707345

2 1337345 504886 832459

3 1337345 394124 943221

4 1337345 290741 1046604

5 1337345 240604 1096741

DCF analysis at 13%


1 -(707345 x 0.885)

2 -(832459 x 0.783)

3 – (943221 x .693)

16

4 –(1046604 x 0.613)

5 - (1096741 x 0.543)

5 +(800000 x 0.543) Sale of scrap

Total -27,34,165

(iii) DCF analysis of proposal of giving the asset on lease :

Period Particulars PV of cash flow

1-5 Lease rent net of tax +[12,00,000 x 0.65(3.432)]

1 Tax savings on Depreciation +[(350000 x 0.877)

2 ------do------------ +(262500 x 0.769)

3 ------do------------ +(196875x0.675)

4 ------do------------- +(147656x0.592)

5 Tax savings on STCL + (162969x.519)]

5 Sale of scrap +[800000 x 0.519]

0 Cost of machine -40,00,000

Total -94142

The machine not to be given on lease.

LEASE V/S HIRE PURCHASELEASE V/S HIRE PURCHASELEASE V/S HIRE PURCHASELEASE V/S HIRE PURCHASE

Q. No. 10: Q. No. 10: Q. No. 10: Q. No. 10: Company X needs a machine which if purchased outright will cost

Rs.10Lakhs. A Hire purchase and Leasing company has offered two alternatives as

below:

Hire purchase :Hire purchase :Hire purchase :Hire purchase : Rs.2,50,000 down payment, 3 annual installments of

Rs.4,00,000 each payable at year end.

Lease : Lease : Lease : Lease : Rs.20,000 initial fees payable on signing the agreement. 3 annual year-end

installments of Rs.4,32,000 each.

Straight line depreciation. Salvage value zero. Tax rate is 30%. Advise the company

as to which alternative implies least cost.


Hire PurchaseHire PurchaseHire PurchaseHire Purchase

Total payment under hire purchase 2,50,000 + 4,00,000x3 =14,50,000

Cash price 10, 00,000

Total interest 4,50,000

INTEREST IN VARIOUS INSTALMENTS:

I 2,25,000, II 1,50,000, III 75,000.

Period Down payment/installment Tax savings Net cash flow

0 - 2,50,000 - -2,50,000

1 -4,00,000 +67,500 -3,32,500

2 -4,00,000 +45,000 -3,55,000

17

3 -4,00,000 +22,500 -3,77,500

Statement showing incremental cash flows on account of hire purchase

PERIOD HP Outright purchase Incremental CFs

0 -250000 -1000000 +750000

1 -332500 - -332500

2 -355000 - -355000

3 -377500 - -377500

Average CF = (332500 + 355000 + 377500) / 3 = 355000

Fake pay back period = 750000 / 355000 = 2.11 App. Cost of HP = 20 %

NPV at 20 %.


0 1 +7,50,000 750000

1 0.833 -3,32,500 -2,76,973

2 0.694 -3,55,000 -2,46,370

3 0.579 -3,77,500 -2,18,573

NPV +8,085

As NPV is positive, the other rate may be lower say, 18%

NPV at 18 %.


0 1 +7,50,000 7,50,000

1 0.847 -3,32,500 -2,81,628

2 0.718 -3,55,000 -2,54,890

3 0.609 -3,77,500 -2,29,898

NPV -16,415

Cost of Hire Purchase:

Lower rate NPV

= Lower rate + ————————————————— × Diff. in rates

Lower rate NPV – Higher rate NPV

-16415

18

= 18 + ----------------- x 2 = 19.34%

-16415 - 8085

LeaseLeaseLeaseLease

Period payments/ Tax savings NET CASH FLOW

0 - 20000 - -20,000

1 -432000 +1,35,600 -2,96,400

2 -432000 +1,29,600 -3,02,400

3 -432000 +1,29,600 -3,02,400

Statement showing incremental cash flows on account of lease

PERIO

D

lease Outright

purchase

Incremental CFs

0 -20000 -1000000 +980000

1 -296400 +100000 -396400

2 -302400 +100000 -402400

3 -302400 +100000 -402400

Average CF = (3,96,400 +4,02,400 +4,02,400 / 3 = 4,00,400

Fake pay back period = 980000 /400400 = 2.45

App. Cost of Lease = 11 %

NPV at 11%


0 1 +9,80,000 +9,80,000

1 0.901 -3,96,400 -3,57,156

2 0.812 -4,02,400 - 3,26,749

3 0.731 -4,02,400 - 294,154

NPV +1,941

As NPV is positive, the other rate may be taken at lower level, say 10%

NPV at 10%


0 1 +9,80,000 +9,80,000

1 0.909 -3,96,400 -360328

2 0.826 -4,02,400 -332382

3 0.751 -4,02,400 -302202

NPV -14,912

Cost of lease:

19

Lower rate NPV

= Lower rate + ——————————————------- × Diff. in rates

Lower rate NPV – Higher rate NPV

-14,912

= 10 + ----------------- x 1 = 10.88 %

-14912 - 1941

Lease is recommended as its cost is lower than that of HP.

MONTHLY LEASE INSTALMENTSMONTHLY LEASE INSTALMENTSMONTHLY LEASE INSTALMENTSMONTHLY LEASE INSTALMENTS

Q. No. 11Q. No. 11Q. No. 11Q. No. 11: Kunti Ltd requires a machine costing Rs.5,00,000. It has received four

lease proposals from different leasing companies.

I : I : I : I : Vasudev Ltd has offered to lease out the machine for a period of 120 months, the

lease rent payable at the end of the month as per the following schedule :

First 36 months Rs.32 per month per Rs.1,000 of the machine cost

Next 24 months Rs.28 per month per Rs.1,000 of the machine cost

Next 60 months Rs.10 per month per Rs.1,000 of the machine cost.

Vasudev Ltd has offered to sell the machine to Kunti Ltd for Rs.1000 after 10 years.

II : II : II : II : Parthsarthy Ltd has offered to lease out the machine for a period of 96 months,

the lease rent payable at the end of the month as per the following schedule :




The lessor will abandon the machine after the expiry of the lease period.

III : III : III : III : Under the offer from Devaki Nandan Ltd., Kunti Ltd has to make a security

deposit of Rs.1,00,000 and pay the lease rent at the end of the months as follows:




After 84 months, the ownership of the machine will be transferred to Kunti Ltd

against the security deposit. Kunti Ltd shall be able to use the machine for further 3

years and after that its scrap value will be nil.

Assume (i) the cost of capital of Kunti Ltd being 12% p.a.(ii) Depreciation rate for tax

purposes : 15% and (iii) Tax rate applicable to Kunti Ltd is 35%. Advise. Present

value factors at 12% p.a.

Year Monthly discounting factor Year end discounting factor

1 0.940 0.893

2 0.839 0.797

3 ? 0.712

4 ? 0.636

5 ? 0.567

20

6 ? 0.507

7 ? 0.452

8 ? 0.404

9 ? 0.361

10 ? 0.322


General assumptions:

(a) The machine is required for 10 years

(b) After 10 Years its value will be zero

Alternative specific assumptions & notes

Alternative I WE shall be paying lease rent for 10 years , we shall not purchase

machine after 10 years as it shall have no value [ see our general assumption (b)]

Alternative II We shall be paying lease rent for 8 years, we shall be using the

machine for 10 years i.e. for 2 years ( year 9th and 10th ) we shall be using the

machine without paying lease rent .

Alternative III No depreciation or tax saving on initial deposit under Income Tax

Act, 1961. Depreciation on this amount will be allowed under WDV method after 7

years when the ownership will be transferred to us.

It is assumed that the machine will be discarded in the beginning of 11th year.

A note on monthly discounting factor:A note on monthly discounting factor:A note on monthly discounting factor:A note on monthly discounting factor:

Monthly discounting factors given in the question represent PV of Cash flow of 1/12

rupee at the end of each month. In other words, these factors represent average of

PVFs calculated on monthly basis.

For example:

Monthly discounting factor for year 1:

1/12[(1/1.01) + (1/1.02) +………+ (1/1.12)] = 0.940

Monthly discounting factor for year PVF

3 0.750

4 0.669

5 0.598

6 0.534

7 0.477

Working note III Alternative

Year Depreciation Tax savings

1 15,000 5,250

2 12,750 4,463

3 10,838 3,793

DCF Analysis of I Proposal

21

YEAR PV OF “LEASE RENT LESS TAX SAVINGS”

1 (-1,92,000 X 0.940) + (0.893 X 67,200) = -1,20,470

2 (-1,92,000 X 0.839) + (0.797 X 67,200) = -1,07,530

3 (-1,92,000 X 0.750) + (0.712 X 67,200) = - 96,154

4 (-1,68,000 X 0.669) + (0.636 X 58,800) = - 74,995

5 (-1,68,000 X 0.598) + (0.567 X 58,800) = - 67,124

6 ( -60,000 X 0.534) + (0.507 X 21,000) = - 21,393

7 ( -60,000 X 0.477) + (0.452 X 21,000) = - 19,128

8 ( -60,000 X 0.426) + (0.404 X 21,000) = - 17,076

9 ( -60,000 X 0.380) + (0.361 X 21,000) = - 15,219

10 ( -60,000 X 0.340) + (0.322 X 21,000) = - 13,638

NPV OF COST 5,52,727

DCF Analysis of II Proposal

YEAR PV OF “LEASE RENT LESS TAX SAVINGS”

1 (-2,40,000 X 0.940) + (0.893 X 84,000) = -1,50,588

2 (-2,40,000 X 0.839) + (0.797 X 84,000) = -1,34,412

3 (-2,40,000 X 0.750) + (0.712 X 84,000) = -1,20,192

4 (-1,68,000 X 0.669) + (0.636 X 58,800) = - 74,995

5 (-1,68,000 X 0.598) + (0.567 X 58,800) = - 67,124

6 ( -60,000 X 0.534) + (0.507 X 21,000) = - 21,393

7 ( -60,000 X 0.477) + (0.452 X 21,000) = -19,128

8 ( -60,000 X 0.426) + (0.404 X 21,000) = -17,076


DCF Analysis of III Proposal

PERIOD PARTICULARS PV

0 SECUIRTY DEPOSIT -1,00,000

PV OF “LEASE RENT LESS TAX SAVINGS”

1 (-1,80,000 X 0.940) + (0.893 X 63,000) = -1,12,941

2 (-1,80,000 X 0.839) + (0.797 X 63,000) = -1,00,809

3 (-1,80,000 X 0.750) + (0.712 X 63,000) = - 90,144

4 (-1,68,000 X 0.669) + (0.636 X 58,800) = - 74,995

5 (-1,68,000 X 0.598) + (0.567 X 58,800) = - 67,124

6 ( -60,000 X 0.534) + (0.507 X 21,000) = - 21,393

7 ( -60,000 X 0.477) + (0.452 X 21,000) = - 19,128

Tax Savings on Depreciation

8 15,000 x 0.35 x 0.404 +2,121

9 12,750 x 0.35 x 0.361 +1,611

10 10,838 x 0.35 x 0.322 +1,221

NPV of Cost 5,81,581

On account of the least cost, I Proposal is recommended.

CALCULATION OF COST OF THE MACHINECALCULATION OF COST OF THE MACHINECALCULATION OF COST OF THE MACHINECALCULATION OF COST OF THE MACHINE

22

Q. No. 12 Q. No. 12 Q. No. 12 Q. No. 12 M/s Gama & Co. is planning of installing a power saving machine and

are considering buying or leasing alternative. The machine is subject to straight-

line method of depreciation. Gama & Co. can raise debt at 14% payable in five

equal annual installments of Rs. 1,78,858 each, at the beginning of the year. In

case of leasing, the company would be required to pay an annual end of year rent

of 25% of the cost of machine for 5 years. The Company is in 40% tax bracket.

The salvage value is estimated at Rs. 24,998 at the end of 5 years.

Evaluate the two alternatives and advise the company by considering after tax

cost of debt concept under both alternatives.

P.V. factors 0.9225, 0.8510, 0.7851, 0.7242, and 0.6681 respectively for 1 to 5

years. (12 Marks) (June 2009)(June 2009)(June 2009)(June 2009)

AnswerAnswerAnswerAnswer :

Let the cost of machine = x

x /(1+ 2.9137) = 1,78858

x = 699998

Calculation of interest and tax savings of interest : Calculation of interest and tax savings of interest : Calculation of interest and tax savings of interest : Calculation of interest and tax savings of interest :


Total borrowing

I Payment

II Payment

III Payment

IV Payment

V payment

6,99,998

1,78,858

5,21,140

1,05,898

4,15,242

1,20,724

2,94,518

1,37,625

1,56,893

1,56,893

1,78,858

1,05,898

1,20,724

1,37,625

1,56,893

Nil

7,2960

58,134

41,233

21,965

Annual depreciation = (6,99,998 – 24,998)/5 = 1,35,000

TEACHING NOTE TEACHING NOTE TEACHING NOTE TEACHING NOTE : may not be given in the exam: Under section 43(b) of the

Income tax Act, 1961, the deduction of interest will be allowed on accrual basis

(as interest is being paid before the date of submission of Income Tax return)

Year Dep. + int. Tax savings PV

1 135000+72960 83,184 76,737

2 135000 +58,134 77.254 65,743

23

3 135000 +41,233 70,493 55,344

4 135000 +21,965 62,786 45,470

5 135000 54,000 36,077

Total 2,79,371

DCF Analysis of purchase proposal


Bank payments 0-4 4,2828 1,78,858 Annually -7,66,013

Scrap 5 0.6681 24,998 + 16,701

Tax savings +2,79,371




Lease rent

less tax

savings

1-5 3.9509 1,05,000Annually -4,14,845



Q. NO. 13 Q. NO. 13 Q. NO. 13 Q. NO. 13 The following data re furnished by he SIGMA leasing Ltd.(SLL).

Investment Rs.99L

Lease period 3 years

Residual value Nil

Pre tax required rate of return 22%

The SLL seeks your advice in determining the annual lease rental under the

following rental structures:

(i) Equated (ii) Stepped (annual increase of 12%) (iii) Ballooned (annual rental of

Rs.15L for year 1 and 2) (iv) Deferred (deferment period 1 year).

You are required to compute the annual rental under four structures.

Answer (i) Answer (i) Answer (i) Answer (i)

Let annual lease rent = x

-99L + x(2.042)= 0

x = 48.48L

Annual lease rent : Rs.48.48L

(ii) Let annual lease rent for period = x

24

-99L + x(0.820) + x(0.672)(1.12) + x(0.551)(1.12)2 = 0

-99L = 2.264x

x = 43.72L

(iii) Let lease rent for 3rd year = x

-99L + 15L(1.492) + x(0.551) = 0

x = lease rent for 3rd year = 139.06L

(iv) Let annual lease rent for 2nd and 3rd year = x

-99L +x(1.223) =0

x= Annual lease rent 80.95L

CROSS – BORDER LEASE

CrossCrossCrossCross----border leasingborder leasingborder leasingborder leasing is a lease arrangement where lessor and lessee are based

in different countries. It is a means of international financing the equipments

requiring huge funds like aircrafts, transport equipments, marine equipments, and

telecommunication equipments etc which have predictable revenue streams.

(Such leases are also referred as Big Ticket Leases). In developing countries,

the local resources may not be available for such financing. The financing is in

the form of debt i.e. the lessor gets the return at fixed rate. It is a safer way of

debt financing as it is easier for a lessor to repossess the leased equipment

following a default by the lessee because the lessor is the owner and not mere

secured lender.

Q. No. 1Q. No. 1Q. No. 1Q. No. 14444 An Indian company is in need of a super computer, operating life of

the super computer being 5 years. Scrap value at the end of the life is estimated

to be nil. It can be purchased for $ 1.50 million with the help of 10% p.a. finance

available in rupees. Alternatively it can be acquired on the basis of lease, annual

lease rent being $ 325000, payable in the beginning of each year for 5 years.

Tax rate : 40%. Depreciation rate: 25% WDV. Interest rates in USA and in India

are 4% and 8% respectively. The spot rate is 1$ = Rs.40.


Working note (1)

Using IRPT;

1 year forward rate: 1$ = 41.54

2 years forward rate : 1$ = 43.14



Working note (2)

Period Lease rent (Rs.)c Tax Savings

0 325000x40.00 = 130.00 Lakhs Nil

25

1 325000x41.54 = 135.00 Lakhs 52.00 Lakhs

2 325000x43.14 = 140.20 Lakhs 54.00 Lakhs

3 325000x44.80 = 145.60 Lakhs 56.08 Lakhs

4 325000x46.52 = 151.19 Lakhs 58.24 Lakhs

5 Nil 60.48 Lakhs

Working note (3)

1.50m x 40

Bank installment = ------------ = 143.8849 Lakhs

1 + 3.17

Calculation of interest


Total borrowing

I Payment

II Payment

III Payment

IV Payment

V payment

600 Lakhs

143.8849 L

456.1151 L

98,2734 L

357.8417 L

108.1007 L

249.7410 L

118.9100 L

130.8302 L

130.8302 L

Nil

143,8849 L

98.2734 L

108.1007 L

118.9100 L

130.8302 L

Nil

45.6115 L

35.7842 L

24.9741

13.0547

Working note (3)

Assumption : The machine will be discarded in the beginning of 6th year.

Year Dep. Dep. + int. Tax savings PV

1 150 L 195.6115 L 78.2446 L 73.7847 L

2 112.50 L 148.2842 L 59.3137 L 52.7892 L

3 84.375 L 109.3491 L 43.7396 L 36.7413 L

4 63.281 L 76.3357 L 30.5343 L 24.1832 L

5 47.461 L 47.4610 L 18.9844 L 14.1813 L

Total 201.6797 L

MAIN ANSWER : DCF ANMAIN ANSWER : DCF ANMAIN ANSWER : DCF ANMAIN ANSWER : DCF ANALYSIS OF PURCHASE PALYSIS OF PURCHASE PALYSIS OF PURCHASE PALYSIS OF PURCHASE PROPOSAL ROPOSAL ROPOSAL ROPOSAL


Bank payments 0-4 4.465 -143.8849 L - 642.4461 L

26

Tax savings +201.6797 L

NPV OF COST - 440.7664 L



Lease rent 0 1 - 130.00 L - 130.00 L

Tax savings 1 0.943 + 52 L + 49.036 L

Lease rent 1 0.943 - 135,00 L -127.305 L

Tax savings 2 0.890 + 54 L + 48.06 L

Lease rent 2 0.890 - 140.20 L -124.778 L

Tax savings 3 0.840 + 56.08 L + 47.1072 L

Lease rent 3 0.840 - 145.60 L -122.304 L

Tax savings 4 0.792 + 58.24 L +46.1261 L

Lease rent 4 0.792 -151.19 L -119.7425 L

Tax savings 5 0.747 + 60.48 L + 45.1786 L

- 388.6216 L

Lease is recommended on account of its lower net present value of cost

Q. No. 15Q. No. 15Q. No. 15Q. No. 15 A Japanese leasing company is to quote lease rent for 5 aircrafts

required by an Indian company. The operating life of the aircrafts may be

assumed to be 5 years, at the end of which it can be disposed off at 10% of its

cost in US market. The cost of each aircraft is $ 10m. The Japanese tax system

allows sum of digit method depreciation to the lessor. Assume income tax rate in

Japan is 25%. Find the annual lease rent, in yens, to be charged so as to provide

4% post return to the lessor. Assume that the lease rent if payable in the

beginning of each year. The spot rate: 1 $ = 120 Yens. Assume that the USD is

expected to depreciate against Yen by 2% p.a.

AnsAnsAnsAnswer (Calculations on the basis of one airwer (Calculations on the basis of one airwer (Calculations on the basis of one airwer (Calculations on the basis of one air----craft)craft)craft)craft)

Working note (1) 5 years forward rate: 1$ = 120 (0.98)5 Yens = 108.4705 Yens

Working note (2) Calculation of Depreciation:

Cost: 1200 million Yens

Sale of scrap: 108.4705 Million Yens

Depreciable amount: 1091.5295 Million Yens

Year Depreciation PV of Tax savings on Dep.

27

1 1091.5295 x(5/15) = 363.8432m Yens 363.8432 x 0.25 x 0.962

2 1091.5295 x(4/15) = 291.0745m Yens 291.0745 x 0.25 x 0.925

3 1091.5295 x(3/15) = 218.3059m Yens 218.3059 x 0.25 x 0.889

4 1091.5295 x(2/15) = 145.5373m Yens 145.5373 x 0.25 x 0.885

5 1091.5295 x(1/15) = 72.7686m Yens 72.7686 x 0.25 x 0.822

Total 250.4878m Yens

PV of sale of scrap = 108.4705 Million Yens x 0.822 = 89.1628 m Yens

Main Answer:

The lessor wants a return of 4%. Hence NPV at 4% should be zero.


PV of lease receipts: y +3.63y = 4,63y

0 = -investment +

PV of lease rent – PV of tax on lease rent +

PV of tax savings on Depreciation + PV of sale of scrap

0 = -1200 + 4.63y – 0.25y (4.452) + 250.4878 + 89.1628

-3.517y = -860.3494

y = 244.6259m Yens

Annual lease rent for five aircrafts = 1223.1295 m Yens

Q. No. 1Q. No. 1Q. No. 1Q. No. 16666 Five aircrafts are required by an Indian company. The operating life of

the aircraft may be assumed to be 4 years, at the end of which it can be disposed

off at 10% of its cost in US market. The cost of each aircraft is $ 10m. The

Indian company can raise the required funds in US market at 6% p.a., the

principal to be payable in four equal annual installments. The pre-tax cost of

debt for the Indian company is 10%, Depreciation rate for tax purpose to be 30%

WDV, tax rate 30%. Alternatively, the Indian company can acquire the aircrafts

on lease from a Japanese company, the leasing company requiring a pre tax 7%

return. Assume that the lease rent is payable at the end of each year. The spot

rate: 1 $ = 120 Yens = Rs.40. Assume no change in foreign exchange rates.


Working note (1)

Repayment (Rs.

Million)

Interest Rs.

Million

Tax savings on

interest Rs. Million

(12.50+3.00)x40 = 620 120 36

(12.50+2.25)x40 = 590 90 27

(12.50+1.50)x40 = 560 60 18

(12.50+0.75)x40 = 530 30 9

Working note (2)

Calculation of tax savings on Dep./STCL (Rs. Million)

Year Depreciation/STCL WDV Tax Savings on Dep./ STCL

28

1 600 Dep. 1400 180

2 420 Dep. 980 126

3 294 Dep. 686 88

4 486 STCL 146

It is assumed that future year 4, the company shall have sufficient

amount of Short Term Capital Gain to set off the STCL of Rs.486m.

Working note (3)

Period Cash flows ( Loan repayment –tax savings) (Rs. Million)

1 -620 + 36 + 180 = -404

2 -590 + 27 + 126 = -437

3 -560 + 18 + 88 = -454

4 -530 + 9 + 146 = -375

4 Sale of scrap 200

Working note (4)

Annual lease rent =[(Rs.2000m) – (Rs.200x0.762)] /3.387 = Rs.545.50m

Annual lease rent (net of tax) = Rs.381.85m

Main answer :

Net present value of cost (lease proposal):-381.85x3.387=-Rs.1293.32m

DCF analysis of purchase proposal

‘Purchase’ is recommended on account of its lower net present value of cost

Q 17Q 17Q 17Q 17: : : : 21st Century Leasing company Ltd, an Indian company, has been

approached by a Singapore company for structuring a lease for a Computer

system costing Rs.10,00,000 for a period of six years after which its scrap value

would be Rs.1,00,000. Depreciation : straight line.

The lessor’s required rate of return is 10% post tax. Tax rate applicable to the

lessor is 30%.

The lessor has to incur SGD 1,000 in the beginning of each year for maintenance

of the computer for which the contract has to be given to a Singapore based

Period PVF CF PV

1 0.935 -404 -377.74

2 0.873 -437 -381.50

3 0.816 -454 -370.46

4 0.762 -375 -285.75

4 0.762 +200 +152.40

NPV of cost -1,308.59

29

Computer Maintenance firm. The lessee proposes to pay the lease rental in SGDs

in the beginning of each year.

Calculate annual lease rent assuming 1 SGD = Rs.25.

Ignore the cost of carrying the supercomputer to Singapore and its scrap back to

India.

Answer Answer Answer Answer

Working note:Working note:Working note:Working note:

Year Depreciation Maintenance Depreciation

+Maintenance

Tax

savings

CF (Maintenance

minus tax

savings)

1 1,50,000 25,000 1,75,000 52500 +27500

2 1,50,000 25,000 1,75,000 52500 +27500

3 1,50,000 25,000 1,75,000 52500 +27500

4 1,50,000 25,000 1,75,000 52500 +27500

5 1,50,000 25,000 1,75,000 52500 +27500

6 1,50,000 25,000 1,75,000 52500 +27500

Let annual lease rent = Rs.y

0 = -10,00,000 + {y.(1 +3.791)} –[ 25,000)(1+3.791)]

– {y -25000 – 150000][0.30].(4.355) + 1,00,000(0.564)

0 = -10,00,000 + 4.791y – 119775 – 1.3065y +2,28,638 + 56400

3.4845y = 834737

y = Rs.2,39,557 = 9582SGD

Annual lease rent (receivable in the beginning of the year) = SGD 9582

EXTREXTREXTREXTRA PRACTICE ( MUST DO )A PRACTICE ( MUST DO )A PRACTICE ( MUST DO )A PRACTICE ( MUST DO )

QQQQ. NO. 18 . NO. 18 . NO. 18 . NO. 18 M/s ABC Ltd is to acquire a personal computer with modem and

printer. Its price is Rs.60,000. ABC can borrow Rs. 60,000 from a bank at 12%

p.a. to finance the purchase. The principal sum is to be repaid in five equal year-

end installments. ABC Ltd can also have the computer on lease for 5 years.

The firm seeks your advise to know the maximum lease rent payable at each

year end. Consider the following additional information:

(a) Interest on loan is payable at each year end.

(b) The full cost of the computer will be written off over the effective life of

computer on a straight line basis and the same will be allowed for tax

purposes.

30

(c) The computer will be sold for Rs.1,500 at the end of the fifth year. The

commission on such sales is 8 per cent on the sale value and the same will be

paid. (d) The company’s effective tax rate is 30 per cent and the cost of capital is 11%.

Suggest the maximum annual lease rental payable by ABC Limited . Discount factors:

( at 11%) 0.901, 0.812, 0.731, 0.659, 0.593. ((((Nov. 2009Nov. 2009Nov. 2009Nov. 2009))))

Borrow Rs.60,000 from bank

Period Loan

repayment

Interest Tax Saving on Interest &

Depreciation

Cash outflow

1 12000 7200 5760 13440

2 12000 5760 5328 12432

3 12000 4320 4896 11424

4 12000 2880 4464 10416

5 12000 1440 4032 9408

Period 5 : sale of scrap net of com. and tax = 1500x.92x0.70 = Rs.966


Period PV of cost

1 13440x 0.901

2 12432x 0.812

3 11424x0.731

4 10416x 0.659

5 9408x 0.593

5 -966x 0.593

42470

Let equal. Lease rent (annual) =X

(0.70X)(3.696) = 42470 X =

Hence annual lease rent ( Maximum) = Rs.16,415

Q. No.1Q. No.1Q. No.1Q. No.19 9 9 9 Sundaram Ltd. discounts its cash flows at 16% and is in the tax bracket

of 35%. For the acquisition of a machinery worth Rs.10,00,000, it has two options

– either to acquire the asset by taking a bank loan @ 15% p.a. repayable in 5

yearly installments of Rs.2,00,000 each plus interest or to lease the asset at

yearly rentals of Rs.3,34,000 for five (5) years.

In both the cases, the instalment is payable at the end of the year. Depreciation

is to be applied at the rate of 15% using ‘written down value’ (WDV) method. You

are required to advise which of the financing options is to be exercised and why.

Year 1 2 3 4 5

P.V factor @16% 0.862 0.743 0.641 0.552 0.476

(14 Marks) ) (JUNE 2009(JUNE 2009(JUNE 2009(JUNE 2009)

31


Borrow Rs.10,00,000 from bank

Period Loan

repayment

Interest Dep. Tax Saving on

Interest &

Depreciation

Cash

outflow

1 2,00,000 1,50,000 1,50,000 1,05,000 2,45,000

2 2,00,000 1,20,000 1,27,500 86,625 2,33,375

3 2,00,000 90,000 1,08,375 69,431 2,20,566

4 2,00,000 60,000 92,119 53,242 2,06,758

5 2,00,000 30,000 78,301 37,905 1,92,095

Assumption : the machine will be discarded in the beginning of 6th year.

% 0.862 0.743 0.641 0.552 0.476


Period PV of cost

1 2,45,000x0.862

2 2,33,375x0.743

3 2,20,566x0.641

4 2,06,758x0.552

5 1,92,095x0.476

Total 7,31,538

Present value of cost under lease alternative : 334000 x 0.65 x 3.274 :

= Rs. 710785

Lease may be preferred as the present value of cost is lower under this

alternative.

Q. No.Q. No.Q. No.Q. No. 20202020 Classic Finance, a leasing company, has been approached by A

prospective customer intending to acquire a machine whose cash down price is

Rs.6.00 Crores. The customer , in order to leverage his tax position, has

requested to quote three year lease rentals payable at year end but in a

diminishing manner in the ratio of 3:2:1. Depreciation can be assumed to be on

WDV basis at 25% and marginal tax rate of Classic Ltd is 35%. The target rate of

32

return for Classic Finance on the transaction is 10%. You are required to

calculate the lease rents to be quoted for the lease. (Nov.2009)(Nov.2009)(Nov.2009)(Nov.2009)


Assumption: Assumption: Assumption: Assumption: Life of the machine is 3 years. The machine will be discarded discarded discarded discarded in the

beginning of the 4th year.

Working note

Year Depreciation

1 1.50 Crores

2 1.125 Crores

3 0.84375 Crores

Present value of cash in flows :

Year Lease

Rent

Tax CF PV

1 3x (3x – 1.50 Cr.)(0.35) =

1.05x – 0.525Cr.

1.95x +

0.525 Cr.

(1.95x+0.525Cr.)X

0909

2 2x (2x – 1.50 Cr.)(0.35) =

0.70x – 0.525

1.30x +

0.525Cr.

(1.30x + 0.525Cr.) X

0.826

3 x (x – 1.50 Cr.)(0.35) =

0.35x – 0.525

0.65x +

0.525 Cr

(0.65x + 0.525 Cr) X

0.751

Total 1.30515 Cr +3.3345x

As the required return is 10%, the NPV at 10% should be zero.

0 = -6.00 Crores +1.30515 Cr +3.3345x

x = 1,40,79,622

Year Lease Rent

1 4,22,38,866

2 281,59,244

33

3 14079622

Q. No. Q. No. Q. No. Q. No. 21212121 XYZ Ltd requires an equipment costing Rs.10,00,000: the same will be

utilized over a period of five years. It has two financing options in this regard:

(i) Arrangement of a Loan of Rs. 10,00,000 at an interest of 13% p.a.; the loan

being repayable in five equal year end installments; the equipment can be sold at

the end of fifth year for Rs. 1,00,000.

(ii) leasing the equipment for a period of five years at an yearly rental of Rs.

3,30,000 payable at year end.

The rate of depreciation is 15% on WDV basis, tax rate 35% and discount rate is

12%. Advise the XYZ Ltd that which of the financing options is to be exercised

and why? (Nov. 2008Nov. 2008Nov. 2008Nov. 2008))))

Answer

Working note :


Calculation of interest and tax savings of interest: Calculation of interest and tax savings of interest: Calculation of interest and tax savings of interest: Calculation of interest and tax savings of interest:

Amount due Principal Interest Tax saving of

interest

Total borrowing

I Payment

II Payment

III Payment

IV Payment

V payment

10,00,000

1,54,333

8,45,667

1,74,396

6,71,271

1,97,068

4,74,203

2,22,687

2,51,516

2,51,516

NIL

1,54,333

1,74,396

1,97,068

2,22,687

251,516

1,30,000

1,09,937

87,265

61,646

32,817

45,500

38,478

30,543

21,576

11,486

YEAR Dep./STCL WDV Tax saving on Dep./STCL

1 1,50,000 Dep. 8,50,000 52500

34

2 1,27,500 Dep. 7,22,500 44625

3 1,08,375 Dep. 6,14,125 37931

4 92,119 Dep. 5,22,006 32242

5 4,22,006 STCL 1,47,702

No WDV depreciation is allowed in the year the asset is sold (when there is no

asset in the Block)

Assumption: In future year 5, the company shall have sufficient amount of STCG

to take tax advantage, by way of set off, of STCL arising in that year.

Year Loan installment Tax savings on Interest &

Depreciation / STCL

CF

1 2,84,333 52500 + 45500 = 98,000 1,86,333

2 2,84,333 44625 + 38478 = 83,103 2,01,230

3 2,84,333 37931 + 30,543 = 68,474 2,15,859

4 2,84,333 32242 +21,576 = 53,818 2,30,515

5 2,84,333 1,47,702 + 11,486 = 1,59,188 1,25,145

DCF analysis at 12%

Year PV of cash flow

1 -1,86,333 x 0.893

2 -2,01,230 x 0.797

3 -2,15,859 x 0.712

4 -2,30,515 x 0.636

5 -1,25,145 x 0.567

5 +1,00,000 x 0.567

Total - 6,41,332

PV of cost under purchase proposal : 6,41,332

PV of cost under lease ; 3,30,000 x 0.65 x 3.605 = 7,73,273

Purchase option (borrowing ) is recommended because of lower amount of cost. Q. No. Q. No. Q. No. Q. No. 22222222: Mahalaxmi Lease Finance Ltd (MLFL) has been approached by a customer

for structuring the lease of a machine. The cost of the machine is Rs.5,00,000. Its

primary life is 5 years. Depreciation rate for tax purposes is 25%. Tax rate

applicable to MLFL is 35%. Calculate the annual lease rent assuming that the lease

rent is payable in the beginning of the year and that the MLFL’s target post tax rate

of return is 9% p.

Answer Answer Answer Answer Note : As per the question, 5 years is the primary lease period. We are not given any

information about secondary lease period. Hence, we ignore the lease rent, tax on

lease rent and tax savings on depreciation for the secondary period.

35

Year Dep. WDV Tax savings PV

1 1,25,000 3,75,000 43,750 40119

2 93,750 2,81,250 32,813 27629

3 70,313 2,10,938 24,609 18998

4 52,734 1,58,204 18,457 13068

5 39,551 1,18.653 13,843 8998

Total 108812


0 = - 5,00,000 + y.(1+ 3.24) + 1,08,812 - 0.35.y.(3.89)

-2.8785y = - 3,91,188.

y= 1,35,900

Annual lease rent receivable in the beginning of the year = Rs.1,35,900

Q. No. 23Q. No. 23Q. No. 23Q. No. 23:::: Mahalaxmi Lease Finance Ltd (MLFL) has been approached by a customer

for structuring the lease of a machine. The cost of the machine is Rs.5,00,000. Its life

is 8 years, scrap value after full life Rs.20,000. Depreciation is allowed for tax

purposes by straight line method. Tax rate applicable to MLFL is 30% for first 4

years and after that it is expected to go up 33%. Calculate the annual lease rent

assuming that the lease rent is payable at the end of the year and that the MLFL’s

target rate of return is 8% p.a.



-5,00,000 + (y)(0.70)( 3.312) + (y)(0.67)( 2.435) + 60,000.(0.30).((3.312) +

(60,000).(0.33).(2.435) + 20,000(0.54) = 0

-3.94985y = -3,81,371

Y = 96,553

Annual lease rent = Rs.96,553

EXTRA PRACTICE QUESTIONS EXTRA PRACTICE QUESTIONS EXTRA PRACTICE QUESTIONS EXTRA PRACTICE QUESTIONS (OPTIONAL)(OPTIONAL)(OPTIONAL)(OPTIONAL)

Q. No.2Q. No.2Q. No.2Q. No.24444: Mahalaxmi Lease Finance Ltd (MLFL) has been approached by a customer

for structuring the lease of a machine. The cost of the machine is Rs.5,00,000. Its

primary life is 5 years. The machine is to be fully written off for tax purposes over

its primary life. Tax rate applicable to MLFL is 35%. Calculate the annual lease rent

assuming that the lease rent is payable in the beginning of the year. The risk free

rate of return is 10% post tax but MLFL wish to mark up this rate by 2 percentage

points to provide premium for the risk in this proposal. Calculate the annual lease

rent.

Let Annual lease rent = y

0 = -5,00,000 + y.(1+ 3.037 ) - ( y – 1,00,000)(0.35)(3.605)

0 = -5,00,000 + 4.037y -1.26175y +126175

- 2.77525 y = - 3,73,825

36

y = 1,34,700

Annual lease rent = 1,34,700.

Q. No. 25Q. No. 25Q. No. 25Q. No. 25: : : : ABC Company has decided to acquire a Rs.5,00,000 Pulp control device

that has a useful life of 10 years. A subsidy of Rs.50,000 is at the time the device is

acquired and placed into the service. Straight line Deprecation, with no salvage

value. Tax rate 50%.If the acquisition is financed with lease, lease payments of

Rs.55000 would be required at the beginning of each year. The company can also

borrow at 10% repayable in 10 equal installments. Debt payments would be due at

the beginning of each year. What is the present value of cash flow for each of these

financing alternatives, using after tax cost of debt? Which alternative is preferable?

(May, 2006)(May, 2006)(May, 2006)(May, 2006)

AnswAnswAnswAnswer er er er

Loan installment ( including interest ) = 4,50,000/(1+5.759) = 66,578

Calculation of interest and tax savings of interest : Calculation of interest and tax savings of interest : Calculation of interest and tax savings of interest : Calculation of interest and tax savings of interest :

Amount due Principal Interest PV of Tax saving of int.

Total

borrowing

I Payment

II Payment

III Payment

IV Payment

V payment

VI payment

VII payment

VIII payment

IX payment

4,50,000

-66758

383422

-28236

3,55,186

-31059

324127

-34165

289962

-37582

252380

-41,340

211040

- 45474

165566

-50021

115545

-55023

60522

-60522

66758

28236

31059

34165

37582

41340

45474

50021

55023

60522

-

38342

35,519

32413

28996

25238

21104

16557

11555

6056

-

19171 x 0.952

17760 x 0907

16207 x 0.864

14498 x 0.823

12619 x 0.784

10552 x 0.746

8279 x 0.711

5778 x 0.677

3028 x 0.645

Total 89810

PV of tax savings on Dep = 22500 x 7.722 = 173745

DCF Analysis of Borrowing AlternativeDCF Analysis of Borrowing AlternativeDCF Analysis of Borrowing AlternativeDCF Analysis of Borrowing Alternative

Period PVF/A CF PV

Payment to Bank 0-9 8.108 -66578 each year -539814

Tax Savings on Dep. 1-10 +173745

Tax savings on interest 1-10 + 89810

Net present value of cost 276259

37

DCF Analysis of Lease AlternativeDCF Analysis of Lease AlternativeDCF Analysis of Lease AlternativeDCF Analysis of Lease Alternative

Period PVF/A CF PV

Lease payment 0-9 8.108 -55000 each year -445940

Tax savings on lease rent 1-10 7.722 + 27500 each year +212355

Net present value of cost 233585

Lease is recommended

Q. No. Q. No. Q. No. Q. No. 26262626: : : : The company is planning to acquire a machine costing Rs.5,00,000.

Effective life of the machine is 5 years. The company is considering two options.

One is to purchase the machine lease and the other is to borrows Rs.5,00,000 from

the bank at 10% p.a. the principal amount of loan will be paid in 5 equal installments

to be paid annually. The machine will be sold at Rs.50,000 at the end of 5th year.

Following further information are given :

(i) Principal, interest and lease rentals are payable at year end

(ii) The machine will be fully depreciated over its effective life.

(iii) Tax rate 30% and after tax cost of capital is 8%.

Compute the lease rentals payable which will make the firm indifferent to loan option. ( May 2007)( May 2007)( May 2007)( May 2007) AnswerAnswerAnswerAnswer

NoteNoteNoteNote:We assume that the sentence “The machine will be fully depreciated over its

useful life” conveys that the full cost of the machine will be depreciated over its

useful life. The full cost can be written off only under straight life method. Hence

annual depreciation = 5,00,000/5 = 1,00,000.

Statement showing annual cash flowsStatement showing annual cash flowsStatement showing annual cash flowsStatement showing annual cash flows

Years → 1 2 3 4 5

Principal & Int. -1,50,000 -

1,40,000

-1,30,000 -1,20,000 -1,10,000

Tax savings on

Depreciation & interest

+45,000 +42,000 +39,000 +36,000 +33,000

Scrap net of tax +35,000

CASH flows -1,05,000 -98,000 -91,000 -84,000 -42,000

DCF ANALYSIS OF BORROWING ALTERNATIVE

Period PVF CF PV

Cash Flows 1 0.935 -105000 -98,175

Cash Flows 2 0.873 -98000 -85,554

Cash Flows 3 0.816 -91000 -74256

Cash Flows 4 0.763 -84000 -64092

Cash Flows 5 0.713 -42000 -29946

Present value of net cost -3,52,023

Let annual lease ( payable at year end) = x

0.70x ( 4.1)= 352023 x = 1,22,656.

Annual lease rent matching with loan option (payable at year end) = 1,22,656.

38

Q. No. 27Q. No. 27Q. No. 27Q. No. 27: : : : ABC leasing Ltd has been approached by a client to write a five years

lease on an asset costing Rs. 10,00,000 and having estimated salvage value of Rs.

1,00,000 thereafter. The company’s after tax required rate of return is 10% and its

tax rate is 50%.

Depreciation 33 1/3 % on WDV method. Annual Lease rent ? ((((May 2006)May 2006)May 2006)May 2006)


Calculation of tax savings on Depreciation and STCL

Year Depreciation/ STCL WDV Tax savings on

depreciation/

STCL

PV of Tax savings

1 3,33,333 6,66,667 1,66,667 1,66,667 x 0.909

2 2,22,222 4,44,445 1,11,111 1,11,111 x 0.826

3 1,48,148 2,96,297 74,074 74,074 x 0.751

4 98,766 1,97,531 49,383 49,383 x 0.683

5 97,531(STCL) 48767 48,767 x 0.621

Total Rs.3,62,920

• It is assumed that in the future year five, ABC Ltd will have sufficient amount

of STCG to set off the short term capital loss of Rs.97,531.

• Under Income Tax Act, 1961, depreciation is not allowed in year the asset is

sold. Hence, Deprecation for future year fiver has not been considered.

• It is assumed that the lease rent is received in the beginning of the year.

• For 10% post tax return, NPV at 10% should be zero.


0 = -10,00,000 + y.(1+ 3.17) – 0.50y.(3.791)+ 1,00,000(0.621)+ 3,62,920

-y(2.2745) = -5,74,980

y = 2,52,794

Annual lease rent ( receivable in the beginning of the year) = Rs.2,52,794

Q. No. 28Q. No. 28Q. No. 28Q. No. 28: : : : Your company is considering to acquire an additional computer to

supplement its time-share computer services to its clients. It has two options :

(i) to purchase the computer for Rs. 22 lakhs.

(ii) to lease the computer for three years from a leasing company for Rs. 5 lakh as

annual lease rent plus 10% gross time share service revenue. The agreement

also requires an additional payment of Rs. 6 Lakhs at the end of 3rd year.

Lease rents are payable at the year-end, and computer reverts to the lessor

after the contract period.

The company estimates that the computer under review will be worth Rs. 10 lakhs

at the end of 3rd year.

Forecast Revenue :

39

Year 1 2 3

Amount (Rs. Lakhs) 22.50 25 27.50

Annual operating costs excluding depreciation/lease rent of computer are estimated

at Rs. 9 Lakhs with additional Rs. 1 lakhs for start up and training costs at the

beginning of the first year. These costs are to be borne by the lessee.

Your company will borrow at 16% interest to finance the acquisition of the computer.

Repayments are to be made according to the following schedule (Rs.’000)

Year end : 1 2 3

Principal 500 850 850

Interest 352 272 136

The company uses straight line method to depreciate its assets and pays 50% tax

on its income. The management approaches you to advice. Which alternative is

recommended and why? (May 2004)(May 2004)(May 2004)(May 2004)

Answer :Answer :Answer :Answer :


Payment to lessor 5 + 2.25 5 + 2.50 5+2.75+6

Tax savings 3.625 3.75 6.875

Net cash outflow 3.625 3.75 6.875

PV 3.35675 3.21375 5.45875 12.02925


Payment to bank 8.52 11.22 9.86

Tax saving on dep.& int. 3.76 3.36 2.68

Sale of scrap 10

Net cash out flow 4.76 7.86 -2.82

PV 4.40776 6.73602 -2.23908 8.9047

Purchase is recommended.Purchase is recommended.Purchase is recommended.Purchase is recommended.

Q. No.29Q. No.29Q. No.29Q. No.29: : : : Engineers Ltd requires a machine which be either bought or taken on

lease. The cost of machine is Rs.20,00,000, useful life 5 years, salvage value

Rs.4,00,000 (consider short term capital loss/gain for the income tax). The purchase

value of the machine can be financed by bank loan at 20% interest repayable in five

equal annual installments falling due at year end. Alternatively, the machine can be

procured on a 5 years lease, year-end rentals being Rs.6,00,000 per annum. The

company follows WDV method of depreciation at the rate of 25%. Tax rate is 35%.

Cost of capital 14%.

(i) Advise the company which option it should choose – lease or borrow.

(ii) Assess the proposal from the lessor’s point of view examining whether leasing

machine is financially viable at 14 % cost of capital. (Nov. 2005)(Nov. 2005)(Nov. 2005)(Nov. 2005)

40



Calculation of interest and tax savings of Calculation of interest and tax savings of Calculation of interest and tax savings of Calculation of interest and tax savings of interest: interest: interest: interest:

Amount due Principal Interest Tax saving of interest

Total borrowing

I Payment

II Payment

III Payment

IV Payment

V payment

20,00,000

2,68,673

17,31,327

3,22,408

14,08,919

3,86,889

10,22,030

4,67,267

5,57,763

5,57,763

2,68,673

3,22,408

3,86.889

4,64,267

5,57,763

4,00,000

3,46,265

2,81,784

2,04,406

1,10,910

1,40,000

1,21,193

98,624

71,542

38,819

YEAR DEP/STCL WDV

1 5,00,000 15,00,000

2 3,75,000 11,25,000

3 2,81,250 8,43,750

4 210938 6,32,812

5 2,32,812(STCL)

Assumption: In future year 5, the company shall have sufficient amount of STCG to

take tax advantage, by way of set off, of STCL arising in that year.

Tax savings on Depreciation / STCL :Tax savings on Depreciation / STCL :Tax savings on Depreciation / STCL :Tax savings on Depreciation / STCL :

Year 1: 1,75,000

Year 2: 1,31,250

Year 3: 98438

Year 4: 73,828

Year 5: 81484

Ye

ar

Loan installment Tax savings on Interest

& Depreciation/STCL

CF

1 6,68,673 3,15,000 3,53,673

2 6,68,673 2,52,443 4,16,230

3 6,68,673 1,97,062 4,71,611

4 6,68,673 1,45,370 5,23,303

5 6,68,673 1,20,303 5,48,370

41

DCF analysis at 13%


1 -3,53,673 x.885

2 -(4,16,230 x ).783

3 – (4,71,611x .693)

4 –(523303x 0.613)

5 - (548370 x 0.543)

5 +(400000 x 0.543) Sale of scrap

Total -13,67,085

DCF analysis of lease proposal = - 3,90,000 x 3.517 = - 13,71,630

Purchase through borrowing is recommended.

(ii)DCF analysis of proposal of giving the asset on lease :

Period Particulars PV of cash flow

1-5 Lease rent net of tax +[6,00,000 x 0.65(3.432)]

1 Tax savings on Depreciation +[(1,75,000 x 0.877)

2 ------do------------ +[1,31,250 x 0.769)

3 ------do------------ +(98438x0.675)

4 ------do------------- +(73828x0.592)

5 Tax savings o n STCL + (81484 x.519)]

5 Sale of scrap +[400000 x 0.519]

0 Cost of machine -20,00,000

Total - 47072

The machine not be given on lease.

Q. No. 30Q. No. 30Q. No. 30Q. No. 30:::: Brij Kishore Ltd requires a machine, the details as follows: Cost

Rs.5,00,000; Life 5 years; Salvage value on completion of life Rs.1,00,000;

Depreciation for tax purpose WDV method: 25%.

The purchase of the machine can be financed through a loan of

Rs.5,00,000 repayable in five equal year-end installments.

The loan carries interest at the rate of 10% p.a.

Alternatively, the machine can be acquired on lease basis, the year-end lease rent

would be Rs.275 per Rs.1000 of the cost of the machine. Assume tax rate to be 40%.

Advise.

42


Working Note No. 1

Bank installment = 5,00,000/3.791 = 1,31,891

Amount Due Principal Interest

I

II

III

IV

V

5,00,000

-81,891

4,18,109

-90,079

3,28,030

-99,088

2,28,942

-1,08,997

1,19,945

-1,19,945

nil

81,891

90,079

99,088

1,08,997

1,19,945

50000

41812

32803

22894

11946

Working note No. 2 :Working note No. 2 :Working note No. 2 :Working note No. 2 :

Depreciation/

STCL

WDV Depreciation/S

TCL + Interest

Tax savings

1 125000 Dep. 375000 1,75,000 70,000

2 93750 Dep. 281250 1,35,562 54,225

3 70313 Dep. 210938 1,03,116 41,246

4 52734 Dep. 158204 75,628 30,251

5 58204 STCL Nil 70,150 28,060

DCF analysis of Purchase proposal

Period PVF/A CF PV

Payment to Bank 1-5 4.212 -131891 Annually -5,55,525

Tax Savings 1 0.943 +70,000 +66,010

____do----- 2 0.890 +54,225 +48,260

----do---- 3 0.840 +41,246 +34,647

----do--- 4 0.792 +30,251 +23,959

----do--- 5 0.747 +28,060 +20,961

Sale of scrap 5 0.747 +1,00,000 +74,700

NPV of cost of purchase proposal 2,86,988

DCF analysis of Lease Proposal

Period PVF/A CF PV

Lease rent net of tax 1-5 4.212 -82,500 Annually -347490

NPV of cost of lease proposal 3,47,490

43

Purchase proposal is recommended.

Q. No.Q. No.Q. No.Q. No. 31313131:::: PQR Ltd. is evaluating a proposal to acquire new equipment. The new

equipment would cost Rs. 3.5 million and was expected to generated cash inflows of

Rs. 4,70,000 a year for nine years. After that point, the equipment would be obsolete

and have no significant salvage value. The company’s weighted average cost of

capital is 16%.

The management of the PQR Ltd. seemed to be convinced with the merits of the

investment but was not sure about the best way to finance it. PQR Ltd. could raise

the money by issuing a secured eight-year note at an interest rate of 12%. However,

PQR Ltd. had huge tax-loss carry forwards from a disastrous foray into foreign

exchange options. As a result, the company was unlikely to be in a position of tax-

paying for many years. The CEO of PQR Ltd. thought it better to lease the equipment

than to buy it. The proposals for lease have been obtained from MGM Leasing Ltd.

and Zeta Leasing Ltd. The terms of the lease are as under:

MGM Leasing Ltd. Zeta Leasing Ltd.

Lease period offered 9 years 7 years

Number of lease rental payments

with initial lease payment due on

entering the lease contract

10 8

Annual lease rental Rs. 5,44,300 Rs. 6,19,400

Lease terms equivalent to

borrowing cost (Claim of lessor)

11.5% p.a. 11.41% p.a.

Leasing terms proposal coverage Entire

Rs. 3.5 million cost

of equipment

Entire

Rs. 3.5 million cost

of equipment

Required:

(i) Calculate the NPV to PQR Ltd. of the two lease proposals.

(ii) Does the new equipment have a positive NPV with (i) ordinary financing,

(ii) lease financing?

(Ada(Ada(Ada(Adapted : PE II Nov. 2004) pted : PE II Nov. 2004) pted : PE II Nov. 2004) pted : PE II Nov. 2004)


(i)

Net Present value of cost under lease from MGM = Rs.5,44,300(1+5.328)

= Rs. 34,44,330

Net Present value of cost under lease from Zeta = Rs.6,19,400(1+4.564)

= Rs. 34,46,342

(ii)

NPV of cost with ordinary financing : - 35,00,000 + 4,70.000 (4.607)

= - 13.34,710

NPV of cost with lease financing : - 34,44,330 + 4,70,000(4.607)

44

= - 12,79,040

The equipment does not have a positive NPV in either of the two cases.

Q. No.Q. No.Q. No.Q. No. 32323232:::: Alfa Ltd desires to acquire a diesel generating set costing Rs.20 Lakh

which will be used for a period of 5 years. It is considering two alternatives (i)

taking the generating set on lease or (ii) purchasing the asset outright by raising

loan. The company has been offered a lease contract with a lease payment of

Rs.5.2 Lakh per annum for five years payable in advance. The company’s banker

requires the loan to be repaid@ 12% p.a. in 5 equal installments, each installment

being due at the beginning of the each year. Tax relevant depreciation is 20%

p.a. WDV. At the end of 5th year the generator can be sold at Rs.2,00,000.

Marginal tax rate of Alfa Ltd is 30% and its post tax cost of capital is 10%.

Determine (i) The net advantage of leasing to Alfa Ltd and recommend whether

leasing is financially viable (ii) Break even lease rental. (May 2010)(May 2010)(May 2010)(May 2010)

AnswerAnswerAnswerAnswer (i)(i)(i)(i)

NoteNoteNoteNote: The question is silent on the point whether the 5 equal installments

would be inclusive interest or plus interest. It is assumed that the loan will be

repaid in 5 equal installments inclusive of interest. This assumption places loan

on an equivalent basis with lease.

Annual Bank installment : (20,00,000) / (1+ 3.037) = 4,95,417Annual Bank installment : (20,00,000) / (1+ 3.037) = 4,95,417Annual Bank installment : (20,00,000) / (1+ 3.037) = 4,95,417Annual Bank installment : (20,00,000) / (1+ 3.037) = 4,95,417


Total borrowing

I Payment

II Payment

III Payment

IV Payment

V payment

20,00,000

4,95,417

15,04,583

3,14,867

11,89,716

3,52,650

8,37,066

3,94,969

4,42,097

4,42,097

nil

4,95,417

3,14,867

3,52,650

3,94,969

4,42,097

1,80,550

1,42,767

1,00,448

53,320

Year Dep./STCL Dep. + int. Tax savings PV @

8.40%

1 4,00,000 Dep. 5,80,550 1,74,165 1,60,667

2 3,20,000 Dep. 4,62,767 1,38,830 1,18,148

3 2,56,000 Dep. 3,56,448 1,06,934 83,951

4 2,04,800 Dep. 2,58,120 77,436 56,918

45

5 6,20,000 STCL 6,20,000 STCL 1,86,000 1,24,270

Total 5,43,954

NOTES ;NOTES ;NOTES ;NOTES ;

(I) NO WDV DEPRECIATION IS ALLOWED IN THE YEAR IN WHICH THE

ASSET IS SOLD.[SECTION 32(1) OF INCOME TAX ACT, 1961]

(II) It is assumed that in future year five the company shall have sufficient

amount of short term capital gain to set off the short term capital loss of

Rs.6,20,000 arising in that year.(STCL CANN’T BE SET OFF AGAINST

BUSINESS INCOME)

(III) Interest included II installment would be allowed as deduction against

taxable income of I year [Section 43(B) of Income Tax Act, 1961] and so

on.

(IV) A lease versus buy analysis is performed when the decision is made to

acquire an asset. “It is not a capital expenditure decision. It is financing

decision. Whether nor not to acquire the asset is not part of typical lease

analysis – in a lease analysis we are simply concerned with whether to

obtain the use of the asset through lease or by purchase.5” Rather we can

say the analysis does not aim to decide lease or purchase (as the

purchase has already been decided); it is to decided whether lease or

borrow. The cash flows of this analysis are more like debt service cash

flows than operating cash flows6. Hence the appropriate discount rate is

the after tax cost of debt.

DCF Analysis of purchase proposal


Bank payments 0-4 4.283 -4,95,417

ANNUALLY

-21,21,871

Tax savings 1-5 3.951 +5,43,954


DCF Analysis of lease proposal PV = PV of lease payments – PV of tax savings.

= 5.20L x 4.283 - 1.56L x 3.951 = 22.2716oL – 6.16356L = 16.10804L

Purchase is recommended.

5 Financial Management – Brigham and Ehrhardt.

6 There is almost no uncertainty in debt –service like cash flows as the cash flows are governed by

the contracts. The operating cash flows are estimated ones, these are not contractual, hence these

are uncertain.

46

Q. No.33: Q. No.33: Q. No.33: Q. No.33: P Ltd had decided to acquire a machine costing Rs,50 Lakhs through

leasing. Quotations from 2 leasing companies have been obtained which are

summarized below :

Quote A Quote B

Lease term 3 years 4 years

Initial lease rent Rs.5.00 Lakhs Rs.1.00 Lakh

Annual lease rent

payable in arrear

Rs,21.06 Lakhs

Rs.19.66 Lakhs

P Ltd evaluates investment proposals at 10% cost of capital and its effective rate

is 30%. Terminal payment in both the cases is negligible and may be ignored.

Make calculations and show which quote is beneficial to P Ltd. Present value

factors at 10% rate for years 1-4 are respectively 0.91, 0.83, 0.75 and 0.66.

Considerations may be rounded off to 2 decimals in Lakhs.


DCF Analysis of each of two proposals regarding Lease

Rs. Lakhs

Quote A Quote B

Period PVF/A CF PV CF PV

Initial lease rent 0 1 -5.00 -5.00 -1.00 -1.00

Tax savings on

Initial lease rent

1

0.91

+1.50

1.37

+0.30

+0.27

Annual lease rent

less tax savings

1-3

2.49

-14.74

-36.71

-13.76

-34.26

---do--- 4 0.68 -13.76 -9.36

NPV -40.34 -44.35

A B

Equalized Annual cost 40.34L/2.49 =Rs.16.20L 44.35L/3.17 = Rs.13.99L

Quote B is recommended.

Alternatively, we may assume that in both the cases we shall be using the

machine for equal period, say 4 years. In one case, we have to pay only for three

years; in the fourth year we can use the machine free of lease rent cost i.e.

without any payment of lease rent. In the second case, we shall use the machine

for four years and we shall be paying the lease rent for four years. In this case,

the answer will be as follows:

47

DCF Analysis of each of two proposals regarding Lease

Rs. Lakhs

Quote A Quote B

Period PVF/A CF PV CF PV

Initial lease rent 0 1 -5.00 -5.00 -1.00 -1.00

Tax savings on

Initial lease rent

1

0.91

+1.50

1.37

+0.30

+0.27

Annual lease rent

less tax savings

1-3

2.49

-14.74

-36.71

-13.76

-34.26

---do--- 4 0.68 -13.76 -9.36

NPV -40.34 -44.35

Quote A is recommended on account of lower absolute amount of NPV.

THEORETICAL ASPECTSTHEORETICAL ASPECTSTHEORETICAL ASPECTSTHEORETICAL ASPECTS

Q.No.34Q.No.34Q.No.34Q.No.34: : : : What are the characteristic features of Financial and operating lease? (Nov. (Nov. (Nov. (Nov.

2006)2006)2006)2006)


A leaseleaseleaselease is a contract conveying from one person (the lessor) to another person (the

lessee) the right to use and control some article of property over the span of the

lease term, without conveying ownership, in exchange for some consideration

(usually a periodic payment.). Leasing is a viable financing alternative to buying with

a loan. Leasing may allow the enterprise to conserve cash. It also allows to avoid

buying equipment which may not be required for long. Companies routinely use

leasing for some of their financing. Airlines lease their airplanes. Car-rental

companies lease their fleets of rental vehicles. Most companies lease some or all of

their office, warehousing, and retailing space.

Basic types of leases:Basic types of leases:Basic types of leases:Basic types of leases:

Finance Finance Finance Finance leases. leases. leases. leases. In this case, the lessor transfers substantially all the risks and

reward of the leased asset to the lessee. Generally this type of lease satisfies one or

more of following conditions:

1. lessee acquires title by the end of lease period

2. option to purchase at bargain price

3. lease period covers major portion of useful life

4. present value of rental payments equals or exceeds asset's fair market value.

5. lease contract is generally non-cancelable.

48

Operating leases: Operating leases: Operating leases: Operating leases: A lease which is not finance lease is known as operating lease.

Features of operating lease:

(i) The lease does not cover the major portion of useful life.

(ii) Lease is generally cancelable.

(iii) Risk of Obsolescence is born by the lesser.

(iv) Generally the cost of maintenance and repair are born by the lessor.

Q..No.35Q..No.35Q..No.35Q..No.35:::: What are the advantages of lease financing?


� It offers fixed rate financing. The lessee has pay lease rent at the same rate

periodically.

� There is less upfront cash outlay. The lessee does not need to make large cash

payments for the purchase of needed equipment.

� Leasing better utilizes equipment. Lessee leases and pays for equipment only

for the time it is needed.

� Lessee has an option to buy equipment at end of lease term. ( only in case of

finance lease )

� Upgrading. As new equipment becomes available the lessee can upgrade to the

latest models each time the lease ends. One of the reasons for the popularity of

leasing is the steady stream of new and improved technology.

� There are a variety of ways in which a lease can be structured. This provides

greater flexibility so that the lease is structured to best accommodate the

individual cash flow requirements of a specific business. For example, there

may be balloon payments, step up or step down payments, deferred payments

or even seasonal payments.

� Generally, it is easier to obtain lease financing than loans from commercial

lenders.

� It offers potential tax benefits depending on how the lease is structured.

Q. No. 36Q. No. 36Q. No. 36Q. No. 36 : : : : Many companies calculate the internal rate of return of the incremental

after-tax cash flows from financial leases. What problems do you think this may give

rise to? To what rate should the IRR be compared? Discuss. ( May, 2001)( May, 2001)( May, 2001)( May, 2001)

Answer: Answer: Answer: Answer:

Calculation of cost of lease by IRR is one of the methods of evaluation of Lease vs.

buy proposals. Under this method, five steps are there

(i) Find cash flows under lease proposal

(ii) Find cash flows under buy proposal ( Here we make an assumption that we do

not have to borrow funds i.e. we have funds to buy the asset and there is no cost of

these funds, we shall be withdrawing this assumption under 5th step.

(iii) Find incremental cash flows i.e. “cash flows of lease minus cash flows of buy”

(iv) Find IRR i.e. cost of lease on the basis of incremental cash flows.

49

(v) We withdraw the assumption we have made under step (ii). We find cost of

borrowed funds for buying the asset. Compare this cost of borrowed funds with the

cost of lease (calculated under step iv). If cost of lease is more than cost of

borrowed funds, buying is recommended. In otherwise situation, lease is

recommended.

Problems which may arise in this method:Problems which may arise in this method:Problems which may arise in this method:Problems which may arise in this method:

(i) IRR may me indeterminate (This may happen if more than one sign reversal

in cash flows is there.)

(ii) Multiple IRRs may be there (This may happen if more than one sign reversal

in cash flows is there.)

(iii) Generally the cash outflows calculated under step (iii) are negative. The

method assumes that funds required for these cash outflows will be

arranged at a cost equal to cost of lease by IRR method.

(iv) Life of the asset may not be equal to the period for which lease is to be

taken. This may complicate the decision.

Q. No.37: Q. No.37: Q. No.37: Q. No.37: Write a short note on Cross Border Lease. (Nov. 2008Nov. 2008Nov. 2008Nov. 2008)


CrossCrossCrossCross----border leasingborder leasingborder leasingborder leasing is a lease arrangement where lessor and lessee are based

in different countries. It is a means of international financing the equipments

requiring huge funds like aircrafts, transport equipments, marine equipments, and

telecommunication equipments etc which have predictable revenue streams.

(Such leases are also referred as Big Ticket Leases). In developing countries,

the local resources may not be available for such financing. The financing is in

the form of debt i.e. the lessor gets the return at fixed rate. It is a safer way of

debt financing as it is easier for a lessor to repossess the leased equipment

following a default by the lessee because the lessor is the owner and not mere

secured lender.

In India, the cross border lease agreements have been entered for acquiring

aircrafts, marine equipments and the containers. The acquisition of these items

requires huge amount of foreign currency funds which are not available at

competitive rates in India. The foreign lessors feel secure here because of the

long history of fair, mature and independent judiciary. The courts have upheld

the rights of lessors of taking repossession of the leased assets in case of

defaults by the lessees.

The main attraction of cross border lease is “Cross-border tax arbitrage”

meaning the “profiting” from differences in the tax systems of two countries.

Suppose in the country of the lessor, depreciation on the leased asset is allowed

to the lessor and in country of the lessee the same is allowed to the lessee, this

means that both the lessor and the lessee can claim depreciation deduction. (In

India, the depreciation deduction of tax purposes is allowed to the lessor). (Cross

50

border tax arbitrage is disappearing fast as most of the countries allow

depreciation to the lessors and not to the lessees). The liberal depreciation

allowance in country of the lessor makes the lease tax efficient for the lessor

and as a result the lessor offers attractive terms for the lease. Sometimes, the

double taxation avoidance agreements between the two counties make the

cross-border lease an attractive deal.

Japan, as lessor, is ahead of all the countries of the world in the field of cross-

border lease. (The reason is low interest rate prevailing in Japan)

The lessee faces the foreign exchange risk in such arrangements (as compared

to domestic lease). The main risk from the lessor point of view is political risk.

RBI has specifically permitted such cross border lease arrangements in which

Indian companies are lessees. Such arrangements are covered under External

Commercial Borrowings.

107475 1139083 Chapter 9 Lease Decisions

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