J B GUPTA CLASSES

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Chapter 9
Lease Decisions
Chapter 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) (iv) IRR Method of Lease Evaluation

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

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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 EVALUATION

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 2

Financial Management Brigham and Ehrhardt.

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.

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(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) Answer Working Notes Annual lease rent = 5,00,000 1 1 + 5.759 = 73976

Tax savings on annual lease rent = 36,988 1 Annual payment to bank= 5,00,000 --1 + 4.607 Table showing interest in various bank payments:
3

= 89,174

Amt. Due I II III IV V VI VII VIII IX

5,00,000 89,174 4,10,826 23,442 3,87,384 27,193 3,60,191 31,543 3,28,648 36,590 2,92,058 42,444 2,49,614 49,236 2,00,378 57,113 1,43,265 66,252

Principal

Interest

Tax Saving of Interest.

89,174 23,442 27,193 31,543 36,590 42,444 49,236 57,113 66,252

65,732 61,981 57,631 52,584 46,730 39,938 32,061 22,922

32,866 30,991 28,816 26,292 23,365 19,969 16,031 11,461

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.

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X
77,013 77,013

77,013

12,161

6,081

NPV METHOD DCF ANALYSIS OF LEASE LEASE PROPOSAL Lease rent Tax savings PERIIOD 0-9 1-10 PVF/A 7.247 6.710 CASHFLOW -73976 annually +36988 annually PV -5,36,104 +2,48,189 -2,87,915

DCF ANALYSIS OF PURCHASE PURCHASE PROPOSAL Bank payments Tax savings PERIIOD 0-9 1 2 3 4 5 6 7 8 9 10 PVF/A 7.247 0.926 0.857 0.794 0.735 0.681 0.630 0.583 0.540 0.500 0.463 CASHFLOW -89,174 89,174 annually +57,866 +55,911 +53,816 +51,292 +48,365 +44,969 +41,031 +36,461 +31,081 +25,000 PV -6,46,244 +53,584 +47,916 +42,730 +37,700 +32,937 +28,330 +23,921 +19,689 +15,541 +11,575 -332321

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

nd Teaching Teaching note: not to be given in the exam: the interest included in 2 payment will be allowed as deduction for income tax purposes against I years 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 years taxable income. And so on. [Section 43(b) of Income tax Act,1961]

COST OF LEASE METHOD (ALSO KNOWN AS IRR METHOD METHOD OF LEASE EVALUATION EVALUATION) ATION INCRREMENTAL CASHFLOWS PERIIOD 0 1 2 3 4 5 6 7 8 9 10 LEASE -73,976 -36,988 -36,988 -36,988 -36,988 -36,988 -36,988 -36,988 -36,988 -36,988 +36,988 PURCHASE -5,00,000 +25,000 +25,000 +25,000 +25,000 +25,000 +25,000 +25,000 +25,000 +25,000 +25,000 INCREMENTAL CASHFLOW +4,26,024 -61988 -61988 -61988 -61988 -61988 -61988 -61988 -61988 -61988 +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 Cost of Lease : -26,753 = 4 + ---------------------------x 2 = 5.42 % -26753 11071 Cost of lease = 5.42% Cost of borrowing = 8%. Lease is recommended. NPV at 4% +426024 -61988x7.435 +11988x0.676 = -26753

WILLIOMSON METHOD (B.S.W METHOD) Financial result = 89,174 (1 + 4.607) 73,976 (1 + 4.607) = + 85,217.

Computation of operating result:

Year

Tax Saving (Lease)

36,988 36,988 36,988 36,988 36,988 36,988 36,988 36,988 36,988 36,988

Tax Saving (Purchase)

25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000 + + + + + + + + + + 32,866 30,911 28,816 26,292 23,365 19,969 16,031 11,461 6,081 0

Net Tax Savings

20,878 19,003 16,828 14,304 11,377 7,981 4,042 527 5,907 11,988

P.V. (8%)

1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

19,333 16,286 13,361 10,513 7,748 5,028 2,154 + 285 + 2,954 + 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 4 SITUATIONS

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 : Q. No. 2, 3 II. Calculating equal lease rent to provide pre tax return to lessor: Lease rent = Apply IRR method ( ignore the tax of Lessor) Example: Q. No. 1. III. Calculating unequal lease rent to provide pre tax return to lessor: Apply IRR method. Example: Q. No. 4. ( ignore the tax of Lessor) IV. Calculating lease rent to provide post tax return to the lessor. Apply IRR method. Example : Q. No. 5,6 (iii) ( consider the tax of Lessor) TEACHING NOTE: 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

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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: 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) (b) (c) (d) (e) The principal amount of the loan will be paid in five annual equal installments. Interest, lease rental, principal repayment are to be paid on the last day of each year. 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. The companys effective tax rate is 40 per cent and the after tax cost of capital is 9 per cent. 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: Borrow Rs.50,000 from Period Loan repayment 1 10000 2 10000 3 10000 4 10000 5 10000 bank Interest 7500 6000 4500 3000 1500

Tax Saving on Interest & Depreciation 7000 6400 5800 5200 4600

CF 10500 9600 8700 7800 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

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Let equal. Lease rent (annual) =X (0.60X)(3.89) = 33843 X = 14500 Hence annual lease rent (equal. To purchase proposal) = Rs.14500 TEACHING 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.3: 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) (b) Advise Welsh Limited about the method of acquiring the car. What should be the annual lease rental to be charged by the leasing company to match the loan option? (May 1996) 1996) (20 Marks)

Answer : (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
4

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

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.

Calculation Calculation of interest : Total borrowing I Payment II Payment III Payment IV Payment V payment Year 1 2 3 4 5 Dep. 25393 25393 25393 25393 25393 Amount due 1,26,965 32,935 94,030 18,830 75,200 21,655 53,545 24,903 28,642 28,642 Principal 32,935 18,830 21,655 24,903 28,642 Interest Nil 14,105 11,280 8,032 4,293 PV 14488 12351 10322 8407 6602

Dep. + int. 39498 36673 33425 29686

Tax savings 15799 14669 13370 11874 10157

DCF ANALYSIS OF PURCHASE PURCHASE PROPOSAL PERIIOD Bank payments Tax savings NPV OF COST 0-4 PVF/A 4.24 CASHFLOW -32,935 PV -1,39,644 +52,170 -87474

DCF ANALYSIS OF LEASE LEASE PROPOSAL PERIIOD Lease rent Tax savings 0-4 1-5 PVF/A 4.24 3.89 CASHFLOW -30,447 Annually +12,179 Annually NPV OF COST -81,719 PV -1,29,095 +47,376

Lease is recommended on account of its lower net present value of cost. Answer (b) Let the required lease rent = y

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-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: 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. Answer 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: 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 Finances 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) 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 : 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

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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) Answer (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: 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)

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Answer Purchase option : Annual installment : 100000 Amount Due Principal 1,10,000 Down payment -10000 10000 Balance Due 1,00,000 I Installment -4925 4925 Balance Due 95,075 II Installment -5,664 5664 Balance Due 89,411 III installment -6,513 6513 Balance Due 82,898 IV installment -7,490 7490 Balance Due 75,408 V installment -8,614 8614 Balance Due 66,794 VI Installment -9,906 9906 Balance Due 56,888 VII installment -11,392 11,392 Balance Due 45,496 VIII installment -13,101 13,101 Balance Due 32,395 IX Installment -15,066 15066 Balance Due 17,329 X Installment -17,329 17329 Balance Due nil /5.0188 = 19925 Interest Nil 15000 14261 13412 12435 11,311 10019 8533 6,824 4859 2596

PV of tax savings on interest and depreciation Year Int. and Tax saving on int. PVF depreciation and Depreciation 1 26000 13000 .930 2 25261 12631 .865 3 24412 12206 .805 4 23435 11718 .748 5 22311 11156 .696 6 21019 10510 .647 7 19533 9767 .602 8 17824 8912 .560 9 15859 7930 .521 10 13596 6798 .484

PV 12090 10926 9826 8765 7765 6800 5880 4991 4132 3290

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Total 6.858 74465

NPV of purchase proposal: Period Payment to Bank 0 ----do------1-10 Tax saving on depreciation and interest Sale of scrap net of tax 10 NPV of cost under purchase proposal NPV of cost under lease = -7,500 x 6.858 Lease is recommended. PV -10,000 -19925 x 6.858 +74465 +10,000 x 0.484 -67,341 -51,435

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) Answer Assumptions: (i) The lessors 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)

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DCF analysis of Lease Proposal Year 1 Year 2 Payment to lessor 85 + 11 85 + 13 Tax savings 48 49 Net cash outflow 48 49 PV 0.926 x48 0,857 x 49

Year 3 85+13 49 49 0.794 x 49

Total

125.35

Year 1 Year 2 Year 3 Total 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 : Working note (Rs.Thousands) Year Lease rent + Depreciation Tax Cash flow revenue share 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: 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. Companys tax rate is 35 per cent and cost of capital is 14 per cent: (i) (ii) Advise the company which option it should choose lease or borrow. Assess the proposal from the lessors 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. 2002) 2002)

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Working note : Answer Loan installment = ( 40,00,000 ) / ( 2.991 ) = 13,37,345 Calculation of interest and tax savings of interest: Total borrowing I Payment II Payment III Payment IV Payment V payment YEAR 1 2 3 4 5 Amount due 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 DEP/STCL 10,00,000 7, 50,000 5,62,500 4,21,875 4,65,625 (STCL) Principal 5,37,345 6,44,814 7,73,777 9,28,532 11,15,532 WDV 30,00,000 22,50,000 16,87,500 12,65,625 Interest 8,00,000 6,92,531 5,63,568 4,08,813 2,21,813 Tax saving of interest 2,80,000 2,42,386 1,97,249 1,43,085 77,635

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 : Year 1: 3,50,000 Year 3:1,96,875 Year 5: 1,62,969 Year 1 2 3 4 5 Loan installment 1337345 1337345 1337345 1337345 1337345

Year 2: 2,62,500 Year 4: 1,47,656

Tax savings on Interest & Depreciation / STCL 630000 504886 394124 290741 240604

CF 707345 832459 943221 1046604 1096741

DCF analysis at 13% Year PV of cash inflow 1 -(707345 x 0.885) 2 -(832459 x 0.783) 3 (943221 x .693)

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4 5 5 Total (iii) Period 1-5 1 2 3 4 5 5 0 (1046604 x 0.613) - (1096741 x 0.543) +(800000 x 0.543) -27,34,165

Sale of scrap

DCF analysis of proposal of Particulars Lease rent net of tax Tax savings on Depreciation ------do-----------------do-----------------do------------Tax savings on STCL Sale of scrap Cost of machine Total

giving the asset on lease : PV of cash flow +[12,00,000 x 0.65(3.432)] +[(350000 x 0.877) +(262500 x 0.769) +(196875x0.675) +(147656x0.592) + (162969x.519)] +[800000 x 0.519] -40,00,000 -94142

The machine not to be given on lease.

LEASE V/S HIRE PURCHASE

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 : Rs.2,50,000 down Rs.4,00,000 each payable at year end. payment, 3 annual installments of

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. Answer Hire 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 0 1 2 Down payment/installment - 2,50,000 -4,00,000 -4,00,000 Tax savings +67,500 +45,000 Net cash flow -2,50,000 -3,32,500 -3,55,000

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

Statement PERIOD 0 1 2 3

showing incremental cash flows on account of hire purchase HP Outright purchase Incremental CFs -250000 -1000000 +750000 -332500 -332500 -355000 -355000 -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 %. PERIIOD 0 1 2 3 NPV As NPV is positive, the other rate may be lower say, 18% NPV at 18 %. PERIIOD 0 1 2 3 NPV PVF/A 1 0.847 0.718 0.609 CASHFLOW +7,50,000 -3,32,500 -3,55,000 -3,77,500 PV 7,50,000 -2,81,628 -2,54,890 -2,29,898 -16,415 PVF/A 1 0.833 0.694 0.579 CASHFLOW +7,50,000 -3,32,500 -3,55,000 -3,77,500 PV 750000 -2,76,973 -2,46,370 -2,18,573 +8,085

Cost of Hire Purchase: Lower rate NPV = Lower rate + Diff. in rates Lower rate NPV Higher rate NPV -16415

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= 18 + ----------------- x 2 = 19.34% -16415 - 8085

Lease Period 0 1 2 3

payments/ - 20000 -432000 -432000 -432000

Tax savings +1,35,600 +1,29,600 +1,29,600

NET CASH FLOW -20,000 -2,96,400 -3,02,400 -3,02,400

Statement showing incremental cash flows on account of lease PERIO lease Outright Incremental CFs D purchase 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% PERIIOD 0 1 2 3 NPV PVF/A 1 0.901 0.812 0.731 CASHFLOW +9,80,000 -3,96,400 -4,02,400 -4,02,400 PV +9,80,000 -3,57,156 - 3,26,749 - 294,154 +1,941

As NPV is positive, the other rate may be taken at lower level, say 10% NPV at 10% PERIIOD 0 1 2 3 NPV Cost of lease: PVF/A 1 0.909 0.826 0.751 CASHFLOW +9,80,000 -3,96,400 -4,02,400 -4,02,400 -14,912 PV +9,80,000 -360328 -332382 -302202

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 INSTALMENTS Q. No. 11: 11 Kunti Ltd requires a machine costing Rs.5,00,000. It has received four lease proposals from different leasing companies. 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 : 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 : First 36 months Rs.40 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 36 months Rs.10 per month per Rs.1,000 of the machine cost. The lessor will abandon the machine after the expiry of the lease period. 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: First 36 months Next 24 months Next 24 months Rs.30 per month per Rs.1,000 of the machine cost Rs.28 per month per Rs.1,000 of the machine cost Rs.10 per month per Rs.1,000 of the machine cost.

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 7 8 9 10 ? ? ? ? ? 0.507 0.452 0.404 0.361 0.322

Answer 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: 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 3 4 5 6 7 Working note Year Depreciation 1 15,000 2 12,750 3 10,838 III Alternative Tax savings 5,250 4,463 3,793 PVF 0.750 0.669 0.598 0.534 0.477

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 NPV OF COST 6,04,908 DCF Analysis of III Proposal PERIOD PARTICULARS 0 SECUIRTY DEPOSIT PV OF LEASE RENT LESS TAX SAVINGS 1 (-1,80,000 X 0.940) + (0.893 X 63,000) = 2 (-1,80,000 X 0.839) + (0.797 X 63,000) = 3 (-1,80,000 X 0.750) + (0.712 X 63,000) = 4 (-1,68,000 X 0.669) + (0.636 X 58,800) = 5 (-1,68,000 X 0.598) + (0.567 X 58,800) = 6 ( -60,000 X 0.534) + (0.507 X 21,000) = 7 ( -60,000 X 0.477) + (0.452 X 21,000) = Tax Savings on Depreciation 8 15,000 x 0.35 x 0.404 9 12,750 x 0.35 x 0.361 10 10,838 x 0.35 x 0.322 NPV of Cost On account of the least cost, I Proposal is recommended.

PV -1,00,000 -1,12,941 -1,00,809 - 90,144 - 74,995 - 67,124 - 21,393 - 19,128 +2,121 +1,611 +1,221 5,81,581

CALCULATION OF COST OF THE MACHINE

22
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 straightline 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) Answer : Let the cost of machine = x x /(1+ 2.9137) = 1,78858 x = 699998 Calculation of interest and tax savings of interest : Amount due Total borrowing I Payment 6,99,998 1,78,858 1,78,858 5,21,140 II Payment 1,05,898 1,05,898 4,15,242 III Payment 1,20,724 1,20,724 2,94,518 IV Payment 1,37,625 1,37,625 1,56,893 V payment 1,56,893 1,56,893 21,965 41,233 58,134 7,2960 Nil Principal Interest

Annual depreciation = (6,99,998 24,998)/5 = 1,35,000 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 1 2 Dep. + int. 135000+72960 135000 +58,134 Tax savings 83,184 77.254 PV 76,737 65,743

23
3 4 5 Total 135000 +41,233 135000 +21,965 135000 70,493 62,786 54,000 55,344 45,470 36,077 2,79,371

DCF Analysis of purchase proposal PERIIOD Bank payments Scrap Tax savings NPV OF COST 0-4 5 PVF/A 4,2828 0.6681 CASHFLOW 1,78,858 Annually 24,998 PV -7,66,013 + 16,701 +2,79,371 4,69,941

DCF ANALYSIS OF LEASE LEASE PROPOSAL PERIIOD Lease rent 1-5 less tax savings NPV OF COST PVF/A 3.9509 CASHFLOW 1,05,000Annually PV -4,14,845

4,14,845

Lease is recommended on account of its lower net present value of cost. Q. NO. 13 The following data re furnished by he SIGMA leasing Ltd.(SLL). Investment Lease period Residual value Pre tax required rate of return Rs.99L 3 years Nil 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) 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) = 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
2

CROSS BORDER LEASE

CrossCross-border 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. 14 14 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. Answer Working note (1) Using IRPT; 1 year forward rate: 1$ = 41.54 2 years forward rate : 1$ = 43.14 3 years forward rate : 1$ = 44.80 4 years forward rate : 1$ = 46.52 Working note (2) Period Lease rent (Rs.)c 0 325000x40.00 = 130.00 Lakhs

Tax Savings Nil

25
1 2 3 4 5 Working 325000x41.54 = 135.00 Lakhs 52.00 Lakhs 325000x43.14 = 140.20 Lakhs 54.00 Lakhs 325000x44.80 = 145.60 Lakhs 56.08 Lakhs 325000x46.52 = 151.19 Lakhs 58.24 Lakhs Nil 60.48 Lakhs note (3) 1.50m x 40 Bank installment = ------------ = 143.8849 Lakhs 1 + 3.17 Calculation of interest Amount due Total borrowing I Payment 600 Lakhs 143.8849 L 456.1151 L II Payment 98,2734 L 357.8417 L III Payment 108.1007 L 249.7410 L IV Payment 118.9100 L 130.8302 L V payment 130.8302 L Nil Working note (3) Assumption : The machine will be discarded in the beginning of 6th year. Year 1 2 3 4 5 Total Dep. 150 L 112.50 84.375 63.281 47.461 Dep. + int. 195.6115 L 148.2842 L 109.3491 L 76.3357 L 47.4610 L Tax savings 78.2446 L 59.3137 L 43.7396 L 30.5343 L 18.9844 L PV 73.7847 L 52.7892 L 36.7413 L 24.1832 L 14.1813 L 201.6797 L 130.8302 L 13.0547 118.9100 L 24.9741 108.1007 L 35.7842 L 98.2734 L 45.6115 L 143,8849 L Nil Principal Interest

L L L L

MAIN ANSWER : DCF ANALYSIS ANALYSIS OF PURCHASE PROPOSAL PROPOSAL PERIIOD Bank payments 0-4 PVF/A 4.465 CASHFLOW -143.8849 L PV - 642.4461 L

26
Tax savings NPV OF COST +201.6797 L - 440.7664 L

DCF ANALYSIS OF LEASE LEASE PROPOSAL PERIIOD Lease rent Tax savings Lease rent Tax savings Lease rent Tax savings Lease rent Tax savings Lease rent Tax savings 0 1 1 2 2 3 3 4 4 5 PVF/A 1 0.943 0.943 0.890 0.890 0.840 0.840 0.792 0.792 0.747 CASHFLOW - 130.00 L + 52 L - 135,00 L + 54 L - 140.20 L + 56.08 L - 145.60 L + 58.24 L -151.19 L + 60.48 L PV - 130.00 L + 49.036 L -127.305 L + 48.06 L -124.778 L + 47.1072 L -122.304 L +46.1261 L -119.7425 L + 45.1786 L - 388.6216 L Lease is recommended on account of its lower net present value of cost Q. 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. Answer Answer (Calculations on the basis of one airair-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 2 3 4 5 1091.5295 x(5/15) = 363.8432m Yens 363.8432 x 0.25 x 0.962 1091.5295 x(4/15) = 291.0745m Yens 291.0745 x 0.25 x 0.925 1091.5295 x(3/15) = 218.3059m Yens 218.3059 x 0.25 x 0.889 1091.5295 x(2/15) = 145.5373m Yens 145.5373 x 0.25 x 0.885 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. Let annual lease rent = y 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. 16 16 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. Answer Working note (1) Repayment Million) (12.50+3.00)x40 (12.50+2.25)x40 (12.50+1.50)x40 (12.50+0.75)x40

= = = =

(Rs. Interest Rs. Million 620 120 590 90 560 60 530 30

Tax savings on interest Rs. Million 36 27 18 9

Working note (2) Calculation of tax savings on Dep./STCL (Rs. Million) Year Depreciation/STCL WDV Tax Savings on Dep./ STCL

28
1 2 3 4 600 420 294 486 Dep. Dep. Dep. STCL 1400 980 686 180 126 88 146

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

sufficient

Main answer : Net present value of cost (lease proposal):-381.85x3.387=-Rs.1293.32m DCF analysis of purchase proposal 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 Purchase is recommended on account of its lower net present value of cost Q 17: 21st Century Leasing company Ltd, an Indian company, has been 17: 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 lessors 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

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 Working note: Year Depreciation

Maintenance Depreciation Tax +Maintenance savings 25,000 25,000 25,000 25,000 25,000 25,000 1,75,000 1,75,000 1,75,000 1,75,000 1,75,000 1,75,000 52500 52500 52500 52500 52500 52500

1 2 3 4 5 6

1,50,000 1,50,000 1,50,000 1,50,000 1,50,000 1,50,000

CF (Maintenance minus tax savings) +27500 +27500 +27500 +27500 +27500 +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
EXTRA EXTRA PRACTICE ( MUST DO )

Q. 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 yearend installments. ABC Ltd can also have the computer on lease for 5 years. The firm year end. (a) (b) seeks your advise to know the maximum lease rent payable at each Consider the following additional information: Interest on loan is payable at each year end.

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)

(d)

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. The companys 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. 2009) 2009) Borrow Rs.60,000 from Period Loan repayment 1 12000 2 12000 3 12000 4 12000 5 12000 Period 5 : sale of scrap bank Interest 7200 5760 4320 2880 1440 net of

Tax Saving on Interest & Cash outflow Depreciation 5760 13440 5328 12432 4896 11424 4464 10416 4032 9408 com. and tax = 1500x.92x0.70 = Rs.966

Present value of cost under purchase proposal: Period 1 2 3 4 5 5 PV of cost 13440x 0.901 12432x 0.812 11424x0.731 10416x 0.659 9408x 0.593 -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.19 No.19 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) 2009

31

Answer Borrow Rs.10,00,000 from bank Period Loan Interest repayment 1 2 3 4 5 2,00,000 2,00,000 2,00,000 2,00,000 2,00,000 1,50,000 1,20,000 90,000 60,000 30,000

Dep.

1,50,000 1,27,500 1,08,375 92,119 78,301

Tax Saving Interest Depreciation 1,05,000 86,625 69,431 53,242 37,905

on Cash & outflow 2,45,000 2,33,375 2,20,566 2,06,758 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 Present value of cost under purchase proposal: Period 1 2 3 4 5 Total PV of cost 2,45,000x0.862 2,33,375x0.743 2,20,566x0.641 2,06,758x0.552 1,92,095x0.476 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. 20 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)

Answer: Assumption: Life of the machine is 3 years. The machine will be discarded in the beginning of the 4th year. Working note Year 1 2 3

Depreciation 1.50 Crores 1.125 Crores 0.84375 Crores

Present value of cash in flows : Year 1 2 3 Total Lease Rent 3x 2x x Tax (3x 1.50 Cr.)(0.35) = 1.05x 0.525Cr. (2x 1.50 Cr.)(0.35) = 0.70x 0.525 (x 1.50 Cr.)(0.35) = 0.35x 0.525 CF 1.95x + 0.525 Cr. 1.30x + 0.525Cr. 0.65x + 0.525 Cr PV (1.95x+0.525Cr.)X 0909 (1.30x + 0.525Cr.) X 0.826 (0.65x + 0.525 Cr) X 0.751 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 1 2 Lease Rent 4,22,38,866 281,59,244

33
3 14079622

Q. No. 21 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. Nov. 2008) 2008)

Answer Working note :

Loan installment = ( 10,00,000 ) / ( 3.517 ) = 2,84,333 Calculation of interest and tax savings of interest: Amount due Total borrowing I Payment 10,00,000 1,54,333 8,45,667 II Payment 1,74,396 6,71,271 III Payment 1,97,068 4,74,203 IV Payment 2,22,687 2,51,516 V payment 2,51,516 NIL 251,516 32,817 11,486 2,22,687 61,646 21,576 1,97,068 87,265 30,543 1,74,396 1,09,937 38,478 1,54,333 1,30,000 45,500 Principal Interest Tax saving of interest

YEAR 1

Dep./STCL 1,50,000 Dep.

WDV 8,50,000

Tax saving on Dep./STCL 52500

34
2 3 4 5 1,27,500 Dep. 1,08,375 Dep. 92,119 Dep. 4,22,006 STCL 7,22,500 6,14,125 5,22,006 44625 37931 32242 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 1 2 3 4 5 Loan installment 2,84,333 2,84,333 2,84,333 2,84,333 2,84,333 Tax savings on Interest Depreciation / STCL 52500 + 45500 = 98,000 44625 + 38478 = 83,103 37931 + 30,543 = 68,474 32242 +21,576 = 53,818 1,47,702 + 11,486 = 1,59,188 & CF 1,86,333 2,01,230 2,15,859 2,30,515 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. 22: 22 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 MLFLs target post tax rate of return is 9% p. 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 1 1,25,000 3,75,000 2 93,750 2,81,250 3 70,313 2,10,938 4 52,734 1,58,204 5 39,551 1,18.653 Total Let annual lease rent = Rs.y 0 = - 5,00,000 + y.(1+ 3.24) + Tax savings 43,750 32,813 24,609 18,457 13,843 PV 40119 27629 18998 13068 8998 108812

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. 23: 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 MLFLs target rate of return is 8% p.a. Answer Let annual lease rent = y -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 (OPTIONAL)

Q. No.24 No.24: 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. 25: 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) Answer Answer Loan installment ( including interest ) = 4,50,000/(1+5.759) = 66,578 Calculation of interest and tax savings of interest : Total borrowing I Payment II Payment III Payment IV Payment V payment VI payment VII payment VIII payment IX payment Total PV of tax savings on Dep = 22500 x 7.722 = 173745 DCF Analysis of Borrowing Alternative Period PVF/A Payment to Bank 0-9 8.108 Tax Savings on Dep. 1-10 Tax savings on interest 1-10 Net present value of cost Amount due 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 Principal 66758 28236 31059 34165 37582 41340 45474 50021 55023 60522 Interest 38342 35,519 32413 28996 25238 21104 16557 11555 6056 PV of Tax saving of int. 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 89810

CF -66578 each year

PV -539814 +173745 + 89810 276259

37

DCF 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. 26: 26: 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)
Answer Note:We assume that the sentence The machine will be fully depreciated over its Note 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 flows Years 1 2 Principal & Int. -1,50,000 1,40,000 Tax savings on +45,000 +42,000 Depreciation & interest Scrap net of tax CASH flows -1,05,000 -98,000

3 -1,30,000 +39,000

4 -1,20,000 +36,000

5 -1,10,000 +33,000 +35,000 -42,000

-91,000

-84,000

DCF ANALYSIS OF BORROWING ALTERNATIVE Period PVF CF Cash Flows 1 0.935 -105000 Cash Flows 2 0.873 -98000 Cash Flows 3 0.816 -91000 Cash Flows 4 0.763 -84000 Cash Flows 5 0.713 -42000 Present value of net cost

PV -98,175 -85,554 -74256 -64092 -29946 -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. 27: 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 companys 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)

Answer Calculation of tax savings on Depreciation and STCL Year Depreciation/ STCL WDV Tax savings on depreciation/ STCL 1,66,667 1,11,111 74,074 49,383 48767 PV of Tax savings

1 2 3 4 5

3,33,333 2,22,222 1,48,148 98,766 97,531(STCL)

6,66,667 4,44,445 2,96,297 1,97,531

1,66,667 x 0.909 1,11,111 x 0.826 74,074 x 0.751 49,383 x 0.683 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.

Let annual lease rent = Rs.y 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. 28: 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 Amount (Rs. Lakhs) 1 22.50 2 25 3 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 : Principal Interest 1 500 352 2 850 272 3 850 136

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) Answer : Payment to lessor Tax savings Net cash outflow PV Year 1 5 + 2.25 3.625 3.625 3.35675 Year 1 8.52 3.76 4.76 4.40776 Year 2 5 + 2.50 3.75 3.75 3.21375 Year 2 11.22 3.36 7.86 6.73602 Year 3 5+2.75+6 6.875 6.875 5.45875 Year 3 9.86 2.68 10 -2.82 -2.23908 Total

12.02925 Total

Payment to bank Tax saving on dep.& int. Sale of scrap Net cash out flow PV Purchase is recommended.

8.9047

Q. No.29: 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 lessors point of view examining whether leasing machine is financially viable at 14 % cost of capital. (Nov. 2005)

40

Answer Loan installment = ( 20,00,000 ) / ( 2.991 ) = 6,68,673 Calculation of interest and tax savings of interest: Amount due Total borrowing 20,00,000 I Payment 2,68,673 17,31,327 3,22,408 II Payment 14,08,919 3,86,889 III Payment 10,22,030 4,67,267 IV Payment 5,57,763 5,57,763 V payment YEAR DEP/STCL 1 5,00,000 2 3,75,000 3 2,81,250 4 210938 5 2,32,812(STCL) Principal 2,68,673 3,22,408 3,86.889 4,64,267 5,57,763 Interest 4,00,000 3,46,265 2,81,784 2,04,406 1,10,910 WDV 15,00,000 11,25,000 8,43,750 6,32,812 Tax saving of interest 1,40,000 1,21,193 98,624 71,542 38,819

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 : Year 1: 1,75,000 Year 2: 1,31,250 Year 3: 98438 Year 4: 73,828 Year 5: 81484 Ye ar 1 2 3 4 5 Loan installment 6,68,673 6,68,673 6,68,673 6,68,673 6,68,673 Tax savings on Interest & Depreciation/STCL 3,15,000 2,52,443 1,97,062 1,45,370 1,20,303 CF 3,53,673 4,16,230 4,71,611 5,23,303 5,48,370

41

DCF analysis at 13% Year PV of cash inflow 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 : Particulars Lease rent net of tax Tax savings on Depreciation ------do-----------------do-----------------do------------Tax savings o n STCL Sale of scrap Cost of machine Total The machine not be given on lease. Period 1-5 1 2 3 4 5 5 0 PV of cash flow +[6,00,000 x 0.65(3.432)] +[(1,75,000 x 0.877) +[1,31,250 x 0.769) +(98438x0.675) +(73828x0.592) + (81484 x.519)] +[400000 x 0.519] -20,00,000 - 47072

Q. No. 30: 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

Answer Working Note No. 1 Bank installment = 5,00,000/3.791 = 1,31,891 Amount Due Principal Interest 5,00,000 I -81,891 81,891 50000 4,18,109 II -90,079 90,079 41812 3,28,030 III -99,088 99,088 32803 2,28,942 IV -1,08,997 1,08,997 22894 1,19,945 V -1,19,945 1,19,945 11946 nil

Working note No. 2 : Depreciation/ STCL 1 125000 Dep. 2 93750 Dep. 3 70313 Dep. 4 52734 Dep. 5 58204 STCL

WDV 375000 281250 210938 158204 Nil

Depreciation/S TCL + Interest 1,75,000 1,35,562 1,03,116 75,628 70,150

Tax savings 70,000 54,225 41,246 30,251 28,060

DCF analysis of Purchase proposal Period PVF/A Payment to Bank 1-5 4.212 Tax Savings 1 0.943 ____do----2 0.890 ----do---3 0.840 ----do--4 0.792 ----do--5 0.747 Sale of scrap 5 0.747 NPV of cost of purchase proposal DCF analysis of Lease Proposal Period PVF/A Lease rent net of tax 1-5 4.212 NPV of cost of lease proposal

CF -131891 Annually +70,000 +54,225 +41,246 +30,251 +28,060 +1,00,000

PV -5,55,525 +66,010 +48,260 +34,647 +23,959 +20,961 +74,700 2,86,988

CF -82,500 Annually

PV -347490 3,47,490

43

Purchase proposal is recommended.

Q. No. 31: 31: 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 companys 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 taxpaying 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. 9 years 10 Zeta Leasing Ltd. 7 years 8

Lease period offered Number of lease rental payments with initial lease payment due on entering the lease contract Annual lease rental Lease terms equivalent to borrowing cost (Claim of lessor) Leasing terms proposal coverage

Rs. 5,44,300 11.5% p.a. Entire Rs. 3.5 million cost of equipment

Rs. 6,19,400 11.41% p.a. 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? (Adapted (Adapted : PE II Nov. 2004) Answer (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. 32: 32: 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 companys 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) Answer (i) Note: Note 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) = 4,95,417
Amount due 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 Principal Interest

Total borrowing I Payment II Payment III Payment IV Payment V payment

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 1 2 3 4

Dep./STCL 4,00,000 3,20,000 2,56,000 2,04,800 Dep. Dep. Dep. Dep.

Dep. + int. 5,80,550 4,62,767 3,56,448 2,58,120

Tax savings 1,74,165 1,38,830 1,06,934 77,436

PV @ 8.40% 1,60,667 1,18,148 83,951 56,918

45
5 6,20,000 STCL Total 6,20,000 STCL 1,86,000 1,24,270 5,43,954

NOTES ; (I) (II) NO WDV DEPRECIATION IS ALLOWED IN THE YEAR IN WHICH THE ASSET IS SOLD.[SECTION 32(1) OF INCOME TAX ACT, 1961] 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 CANNT BE SET OFF AGAINST BUSINESS INCOME) 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. 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.

(III)

(IV)

DCF Analysis of purchase proposal

PERIIOD Bank payments Tax savings NPV OF COST 0-4 1-5 PVF/A 4.283 3.951 CASHFLOW -4,95,417 ANNUALLY PV -21,21,871 +5,43,954 15,77,917

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 6

Financial Management Brigham and Ehrhardt.

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: 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.

Answer 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 40.34L/2.49 =Rs.16.20L B 44.35L/3.17 = Rs.13.99L

Equalized Annual cost 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 ASPECTS
Q.No.34: Q.No.34: What are the characteristic features of Financial and operating lease? (Nov. 2006) Answer A lease 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: Finance 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: 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.35: Q..No.35: What are the advantages of lease financing? Answer: 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. 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) 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: (i) (ii) (iii) IRR may me indeterminate (This may happen if more than one sign reversal in cash flows is there.) Multiple IRRs may be there (This may happen if more than one sign reversal in cash flows is there.) 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. Life of the asset may not be equal to the period for which lease is to be taken. This may complicate the decision.

(iv)

Q. No.37: Write a short note on Cross Border Lease. (Nov. Nov. 2008) 2008 Answer CrossCross-border 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

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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 crossborder 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.

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