"Distances never separate any relation,

Time never builds any relation.

If feelings are true from heart,
then friends are always friends ever and
forever"

LEASING DECISIONS
 CHAPTER
LEASING DECISIONS
LEASING DECISIONS
A financial service includes leasing decision. A lease contract has two parties’ lessor
(leasing co.) and lessee.
The lessor is the owner of assets. He purchases the leased assets and provides it to
lessee for agreed lease period. At the end of the period the assets is given back to
the lessor.
Under financial decision the lease is an operating lease. As-19 does not apply here.
The lessee will not be the owner of the assets till the ownership is finally transferred
to him. The lessee pays lease rent and receives tax saving on lease rent. The lessor
will continue to be the owner of assets. He receives lease rent and pays tax on it. He
is entitled to provide depreciation and claim the tax saving on depreciation. The lease
rent may be payable at the beginning of the year or at the end of each year as agreed
between the parties but the tax saving on lease rent is available to lessee only at the
end of each year.

COMPARISON OF LEASED AND OWNED ASSETS

The person may acquire assets on lease, pay lease rent and receive tax saving on
rent.
Alternatively
He may purchase the assets. He may invests his own fund or raise loan from bank.
If bank loan is raised then there is no outflows out of own pocket at starting point.
The loan is to be raised; this money is paid to seller of assets.
(1) At timely interval (normally one year) the interest is payable. The principal
amount of loan is also repaid in installments. The borrower gets tax saving on
interest.
(2) He is the owner of assets and hence charges depreciation. He claims tax saving
on depreciation.
(3) To match with lease agreement the period of loan and lease is kept equal.
At the end of period the assets is sold and salvages are realized. This salvage is
subject to capital gain tax. The salvage (net of tax) is assumed to be the inflows.
The cost of capital is used as discount rate to find out the present value of outflows
under lease and bank loan proposal. The proposal with lowest PV of outflows is
accepted.
Note: when cost of capital (discount rate) is not given in the question, we take bank
interest rate (net of tax) as discount rate for both proposals.
LEASE PROPOSAL
EVALUATION BY LEASING COMPANY (LESSOR)
Leasing company provides assets on lease. It purchases the assets and hence initially
there is cash outflow.
It receives the lease rent, pays tax on lease rent.
It charges depreciation on assets and claims tax saving thereon.
At the end of lease period, we assume the asset is sold and salvages are realized.
The capital gain tax, if any, is paid by lessor.
The NPV of proposal is calculated.
If NPV is positive, the leasing proposal is accepted.
If NPV is positive, the leasing proposal is accepted.
Note: when lease rent is to be calculated as missing figure, the NPV at required
rate of return is nil. It means the requirement has exactly met.

The present value of inflows discounted at required rate of return is exactly equal
to outflows.

WHEN WE HAVE TO COMPARE LEASE VS BANK FINANCE AND LEASE RENT

PAYABLE TO LESSOR IS TO BE CALCULATED
We apply the pre-tax required return of leasing company and find an equal lease
rent. This rent provides the leasing company a return equal to pre-tax required return
on mount invested in leased assets.
Cost of leased asset

Annual equal rent =-------------------------------------------------------------

Sum of PVF at pre-tax required return for given period

WHEN THE LEASE RENT IS TO BE CALCULATED AS CHARGED BY LEASING

COMPANY
We are provided the details of leasing company, its tax rate etc.
We compare the cost of assets with the present value of post-tax inflows in the form
of rent, tax saving on depreciation and salvage and find lease rent.
Note: When we have to compare two proposals with unequal life, the decision is not
based on NPV or PV of net outflows. In such case we have to calculate annualized
equal NPV (EANPV) or equal annualized cash outflows (EAC) and take decision
accordingly.
EAC specifies the equal annualized outflows for unequal outflows over given period.
We compare equal annual year end outflows and select the alternative with lower
EAC.
LEASE FINANCING
Leasing is an arrangement that provides a firm with the use and control over assets
without buying and owning the same. It is a form of renting assets. Lease is a contract
between the owner of asset (lessor) and the user of the asset called the lessee, where
by the lessor gives the right to use the asset to the lease over an agreed period of
time for a consideration called the lease rental. The contract is regulated by the terms
and conditions of the agreement. The lessee pays the lease rent periodically to the
lessor as regular fixed payments over a period of time.
Types of Leasing
There are two basic kinds of leases:
(i) Operating or Service Lease
(ii) Financial Lease.
Operating or Service Lease
An Operating Lease is usually characterized by the following features:
1. It is a short term lease. The lease period in such a contract is less than the
useful life of asset.

2. The lease is usually cancellable at short- notice by the lessee.

3. As the period of an operating lease less than the useful life of the asset, it does
not necessarily amortize the original cost of the asset. The lessor has to make
further leases or sell the asset to recover his cost of investment and expected
rate of return.

4. The lessee usually has the option of renewing the lease after the expiry of lease
period.

5. The lessor is generally responsible for maintenance, insurance and taxes of the
asset.

6. As it is a short term cancellable lease, it implies higher risk to the lessor but
higher lease rentals to the lessee.

Operating or service leasing is common to the equipment’s which require expert

technical staff for maintenance and are exposed to technological developments, e.g.;
computers, vehicles, data processing equipment’s, communications systems, etc.
Operating lessors usually limit their activities to field and engage themselves in the
purchase of large number of similar types of machines or equipment. They are able
to offer attractive terms to their customers because savings in maintenance costs.
Financial Lease
A lease is classified as Financial Lease if it ensures the lessor for amortization of the
entire cost of investment plus the expected return on capital outlay during the terms
of the lease. Such a lease is usually for a longer period and non-cancellable. Financial
Leases are commonly used for leasing land, building, machinery and fixed equipment,
etc.
A Financial Lease is usually characterized by the following features:
1. The present value of the total lease rentals payable during the period of the
lease exceeds or is equal substantially the whole of the fair value of the leased
asset. It implies that within the lease period, the lessor recovers his investment
in the asset along with an acceptable rate of return.

2. As compared to Operating Lease, a Financial Lease is for a longer period of

time.

3. It is usually non-cancellable by the lessee prior to its expiration date.

4. The lessee is generally responsible for the maintenance, insurance and services
of the asset. However, the terms of lease agreement, in some cases may
require the lessor to maintain and service the asset. Such an arrangement is
called ―maintenance or gross lease‖. But usually in an Operating Lease, it is
lessee who has to pay for maintenance and service costs and such a lease is
known as ―net lease‖.

5. A Financial Lease usually provides the lessee an option of renewing the lease
for further period at a normal rent.

Q. Explain Operating Lease.

SALE AND LEASE BACK

It is an arrangement under which an entity sells the asset to another party and
simultaneously takes it back from the other party under a lease arrangement. The
important features of sale and lease back arrangement are:
(1) The lessee gets a lumpsum amount as sale consideration of the asset.
(2) The lessee continues to use the asset.
Q. Explain ‘Sale and Lease back’.

ADVANTAGES OF LEASING
1. Lease may be • Leasing is alternative to purchasing.
low cost • As the lessee is to make a series of payments for
alternative using an asset, a lease agreement is similar to debt
contract.
• The benefit of lease is based on a comparison
between leasing and buying an asset.
• Many lessees find lease more attractive because of
low cost.
 • For example: You are transferred to another city for
6 months. For daily travel you need a car. If you buy
car in your own name than you have to pay one-time
road tax and incur other expenses besides cost of car.
You will sell the car after 6 months before leaving. It
may be economical to take a car on lease for 6
months as lease rental may be less than net cash
outflow arising from difference between total cost of
car and sale value you realize.
2. Tax benefit There is tax benefit available on payment of lease rent which
may be higher than the tax benefit available on depreciation.

3. Working capital When a firm buy an equipment by borrowing from a bank or

conservation financial institution, they never provide financing. For
example, if bank provides 75% then 25%, the firm has to
bring in from its own source which will reduce the firm’s
working capital (liquidity). But in case of lease there is no
requirement of down payment. This enables conservation of
working capital.

4. Preservation of As per the accounting standard operating lease is not

debt capacity capitalized in the books of the lessee. Operating lease
payment is treated as expenditure in the profit and loss
account. While financing will increase debt equity ratio, so
lease preserve the firm’s debt capacity.

5. Obsolescence After purchase of asset there may take place technological

and disposal obsolescence of the asset. In case of cancellable operating
lease, the lessee can terminate the contract in case of
technological obsolescence.
CALCULAION OF PV OF CASH OUFLOWS (LEASE)
Q. 1. The following details relate to an investment proposal of XYZ Ltd.
Investment outlay ` 100 lakhs
Lease Rentals ` 180 per `1000
Term of lease 8 years
Cost of capital for the firm 12%
Find the Present Value of Lease Rentals if:
a. Lease Rentals are payable at the end of the year.
b. Lease Rentals are payable at the beginning of the year.
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COMPARISON OF LEASED AND OWNED ASSETS
Q. 2. DREAM ltd. is considering proposal to acquire a machine costing ` 2, 00,000
under borrow to purchase option. The payment under this alternative will be as
follows:
Year-end Principal (`) Interest (`) Total (`)

1 60,000 24,000 84,000

2 50,000 20,000 70,000

3 40,000 16,000 56,000

4 30,000 12,000 42,000

5 20,000 8,000 28,000

The instalments are payable at the end of each year. Another option before it is to
acquire the asset on lease rental of ` 50,000 per annum payable at the beginning of
each year for 5 years.
The following information is also available:
(1) Terminal scrap value of asset is nil.
(2) The company provides 20% depreciation on straight-line method on the
original cost.
(3) Income tax rate is 40%.
Which alternative do you recommend? (Use post-tax discount rate 10% p.a.).
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Q. 3. Your company is considering to acquire an additional computer to supplement its time-
share computer services to its clients. It has two options:
(1) To purchase the computer for ` 22 lakhs.
(2) To lease the computer for three years from a leasing company for ` 5 lakhs as annual
lease rent plus 10% of gross time-share service revenue. The agreement also requires an
additional payment of ` 6 lakhs at the end of the 3rd year. Lease rentals are payable at the
year-end, and the computer reverts to the lessor after the contract period.
The company estimates that the computer under review will be worth ` 10 lakhs at the end
of 3rd year.
Forecast revenues are:
Year 1 2 3
Amount (` in lakhs) 22.5 25 27.5
Annual operating costs excluding depreciation/lease rent of computer are estimated at ` 9
lakhs with an additional ` 1 lakh for start up and training costs at the beginning of the first
year. These costs are to be borne by lessee. You company will borrow at 16% interest to
finance the acquisition of the computer. Repayments are to be made according to the
following schedule:
Year end 1 2 3
Principal (000) 500 850 850
Interest (000) 352 272 136
The company uses straight line method (SLM) to depreciate its assets and pays 50% tax on
its income. The management approaches you to advice. Which alternative would be
recommended and why?
Note: The PV factor at 8% and 16% rates of discount are:
Year 1 2 3
8% .926 .857 .794
16% .862 .743 .641
Ans: PV of cash outflows = Buy = 8,90,470; Lease = 12,02,925;
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REPAYMENT OF BORROWED FUND IN EQUTAED ANNUAL INSTALMENTS
Q. 4. The Sharda Beverages ltd. has taken a plant on lease, valued at ` 20 crores. The lease
arrangement is in the form of a leveraged lease. The kuber leasing ltd. is the equity
participant and the Hindustan bank ltd. (HBL) is the loan participant. The fund the
investment in the ratio of 2:8. The loan from HBL carries a fixed rate of interest of 19%,
payable in 6 equated annual instalments. Compute the equated annual instalments from the
point of view of HBL.
PVAF @ 19% for 6 years = 3,4098;
Ans: 4,69,23,573
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Q. 5. Basic information:
(1) Asset related: Cost ` 120 Lakhs; Useful life – 4 years;
(2) Leasing: Full payout; Three-year lease; Lease quote ` 434 per 1,000; Payment annually in
arrears;
(3) Cost of capital rate = 15%
(4) Borrow and buy three-year loan; Interest rate 15%;
Required:
(1) Calculate PV of Annual lease rent;
(2) Calculate instalment amount if loan is repayable in equated annual instalment.
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Q. 6. Precision instruments limited manufacture ball bearings. The company plans to
add some more product lines and so, it has decided to acquire a machine costing `
50 lakhs having a useful life 5 years, with a salvage value of ` 10 lakhs. Consider
short-term capital loss/gain for income tax. The full purchase value of the machine
can be financed by bank loan at the rate of 10% per annum repayable in 5 equal
instalments falling due at the end of each year. Alternatively, the machine can be
procured on a 5-year lease, yearend lease rentals being ` 12.50 lakhs per annum.
The company follows the written down value method of depreciation at the rate of
25%. The company is in 30% tax bracket.
Required:
(1) What is the present value (PV) of cash outflow for each of these financing
alternatives using the after-tax cost of debt?
(2) Which of the two alternatives is preferable?
Note: extracts from the PV table:
PVIF at 7% for 0 to 5 years are:
1 .9346 .8734 .8163 .7629 .7130

PVIF at 10% for 0 to 5 years are:

1 .9091 .8264 .7513 .683 .6209

PVIFA for 5 years at 10% = 3.7908

PVIFA for 5 years at 7% = 4.1002
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Q. 7. Outlook ltd a small manufacturing firm is considering the acquisition and the
use of a machine. After evaluating equipment’s offered by seven different
manufacturers, it has come to the conclusion that “Z” was the most suitable machine
for its needs. Consequently, it has asked the manufacturers sales personnel to
provide information on alternative financing plans available through their financing
subsidiary. The subsidiary presented the following two alternatives:
Alternative I was to lease the “Z” equipment for 7 years, which was the machine’s
expected useful life. The annual lease payments would be ` 14,700 and would include
service and maintenance. Lease payments would be due at the beginning of the year.
Lease payments would be fully tax-deductible from beginning of the year.
Alternative II would be to purchase the “Z” equipment through 100% loan from the
financing subsidiary. The cost of the machine is ` 50,000. It would make seven annual
payments of ` 9,935 each to repay the loan of ` 50,000. Payments would be at the
end of each year.
The company’s marginal tax rate is 44%. It has estimated that the equipment has
expected salvage value of ` 1,000. The company plans to depreciate the equipment
by using straight line method. The service and maintenance would cost ` 3,700
annually.
You are required to advice the company on the desirability of the alternative plans,
assuming that the rate of interest is 9%.
Note: the relevant PVF are:
 Year 0 1 2 3 4 5 6 7

PVF 1 .952 .907 .864 .823 .784 .746 .711

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Q. 8. A firm need an asset for which it is considering the following two options:
(1) Purchasing the asset for ` 1,00,000 borrowing the amount @ 12% interest and repaying
the same together with interest in 4 equal annual instalments.
(2) Acquiring the asset on lease with a payment of annual lease rentals of ` 30,000 per annum
for 4 years.
The firm follows straight line method of depreciation and the income tax rate applicable to
the firm is 30%. Which is a better option to the firm – lease or buy?
Ans: PV of cash outflows = Lease = 68,937; Buy = 75,214;
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Q. 9. Lee Industries wishes to install a plant in its factory at a cost of ` 100 lacs. It can
lease the plant from LOR Co. for 3-year end payments of 34 lacs. LOR will maintain the plant
at ` 5 lacs per annum payable at the end of each year with no charge to Lee for maintenance.
Alternatively, Lee could borrow ` 100 lacs from the bank, either take an upfront extended
warranty for 3 years for an additional 10 lacs, or incur 5 lacs maintenance charges like LOR
without this extended warranty. Bank loan would involve an initial payment of ` 1 lac and
three-year end equated payments of principal together with 14% interest. The plant will
qualify for annual depreciation of 31 lacs and 7 lacs is the expected salvage value. Both LOR
and Lee have an after tax weighted average cost of capital of 10% and a tax rate of 50%.
Find out if the extended warranty is worthwhile.
Compute the Net Advantage to Leasing for Lee under the better option chosen for
maintenance. Assume that extended warranty costs qualify for tax deduction at the end of
year 1. Consider interest rate net of tax for buying vs lease decision.
While evaluating this proposal for LOR, which discount rate would you use to determine the
present value of the cash flows? Why?
(Show calculations in ` lacs up to 2 decimal places and use p.v. factors up to 3 decimal places.
Present your cash flows for each year.) (December 2017)
Ans: PV of lease rent = 44.608; PV of extended warranty = 5,45,500; PV of
maintenance = 6,21,500; PV of cash outflows in buying = 58.93;
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Q. 10. MARUTI ltd requires a plant costing ` 200 lakhs for a period of 5 years. The
company can use the plant for the stipulated period through leasing arrangement or
the requisite amount can be borrowed to buy the plant. In case of leasing, the
company received a proposal to pay annual lease rent of ` 48 lakhs at the end of
each year for a period of 5 years.
In case of purchase, the company would have a 12%, 5 years loan to be repaid in
equated annual instalment becoming due in the beginning of each year. It is
estimated that plant can be sold for ` 40 lakhs at the end of 5th year. The company
uses straight line method of depreciation. Corporate tax rate is 30%. Cost of capital
after tax for the company is 10%.
The PVIF @ 10% and 12% for the five years are given below:
Year 1 2 3 4 5

PVIF @ .909 .826 .751 .683 .621

10%

PVIF @ .893 .797 .712 .636 .567

12%

You are required to advise whether the plant should be purchased or taken on lease.
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EQUAL ANNUAL CASH OUTFLOWS
Q. 11. ABC company ltd. is faced with two options as under in respect of acquisition of an
asset valued ` 1, 00,000.
(a) To acquire the asset directly by taking a bank loan of ` 1, 00,000 repayable in 5 year-
end instalments together with interest of 15%, or
(b) To lease the asset at rentals of ` 320 per ` 1,000 of the asset value for 5 years payable
at year end.
The following additional information is available:
(1) The rate of depreciation of the asset is 15% WDV.
(2) The company has an effective tax rate of 50%.
(3) The company employs a discounting rate of 16%.
You are to indicate in your report which option is more preferable to the company. Restrict
calculation over a period of ten years.
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LEASE PROPOSAL
EVALUATION BY LEASING COMPANY (LESSOR)
Q. 12. ABC ltd. Company provides a car on lease. The cost of car is ` 5, 00,000
Lease period 5 years

Annual lease rent 1,50,000 p.a.

Depreciation method Straight line

Sale value of car at the end of 5th year 50,000

Tax rate 40%

Post tax cost of capital 10%

Evaluate the lease proposal.

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WHEN THE LEASE RENT IS TO BE CALCULATED AS CHARGED BY LEASING
COMPANY
Q. 13. ABC leasing ltd. is in the process of making out a proposal to lease certain equipment.
The cost of the equipment is ` 10,00,000 and period of lease is 10 years. The following
additional information is available. You are required to determine the equated annual lease
rent to be charged for the proposal.
(1) The machine can be depreciated fully over the 10 years on straight line basis.
(2) The current effective tax rate is 40% and expects to go down to 30% from the beginning
of the 6th year of the lease.
(3) It is the normal objective to make a 10% post-tax return in its lease financing.
(4) Lease management fee of 1% of the value of the asset is usually collected from the
lessee upon signing of the contract of lease, to cover the overhead costs related to
processing of the proposal.
(5) Annual lease rents are collected at the beginning of every year.
Ans: 1,71,453;
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Q. 14. The Sharda Beverages ltd. has taken a plant on lease, valued at ` 20 crores. The lease
arrangement is in the form of a leveraged lease. The kuber leasing ltd. is the equity
participant and the Hindustan bank ltd. (HBL) is the loan participant. They fund the
investment in the ratio of 2:8. The loan from HBL carries a fixed rate of interest of 19%,
payable in 6 equated annual instalments. The lease term is 6 years, with lease rental payable
annually in arrears.
(1) Compute the equated annual instalments from the point of view of HBL.
(2) If the lease rent is unknown, and pre-tax yield is 25%, what is the minimum lease rent
that must be quoted?
PVAF @ 19% for 6 years = 3,4098;
Ans: (1) 4,69,23,573 (2) 6,04,76,463;
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Q. 15. HB finance ltd. is considering to enter the computer leasing business. Mainframe
computers can be purchased for ` 2,00,000 each and in turn, be leased out at ` 50,000 per
year for 8 years with an initial payment occurring at the end of first year. You may ignore
tax and depreciation.
(a) Estimate IRR for the company.
(b) What should be the yearly lease payment charged by the company in order to earn a 20%
annual compounded rate of return?
(c) Assume that the firm uses the straight-line method of depreciation, there is no salvage
value, the annual expenses are ` 20,000and the tax rate is 35%. Calculate the yearly lease
payment in order to enable the firm to earn 20% after tax annual compounded rate of
return.
(d) Further, assume that computer has a resale value of ` 40,000. Determine the revised
lease rental to enable the firm to earn 20%.
PVAF @ 20% for 8 years = 3.8372; PVF @ 20% for 8th year = .23257;
Ans: (1) 18.63%; (2) 52,120; (3) 86,725; (4) 85,687;
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Q. 16. ELITE builders, a lending construction company have been approached by a foreign
embassy to build for them block of six flats to be used as guest houses. As per the terms
of contract the foreign embassy would provide ELITE builders the plans and the land costing
` 25, 00,000. ELITE builders would build the flats at their own cost and lease them out to
the foreign embassy for 15 years at the end of which the flats will be transferred to the
foreign embassy for a nominal value of ` 8, 00,000.
ELITE builders estimate the cost of constructions as follows:
Area per flat 1,000 sq. ft.

Construction cost ` 400 per sq. ft.

Registration and other costs 2.5% of cost of construction

ELITE builders will also incur ` 4, 00,000 each in years 14 and 15 towards repairs.

ELITE builders propose to charge the lease rentals as follows:

Year Rentals

1 to 5 Normal

6 to 10 120% of normal

11 to 15 150% of normal

ELITE builder’s present tax rate average at 35%. The full cost of construction and
registration will be written off over 15 years and will be allowed for tax purposes. You are
required to calculate the normal lease rental per annum per flat.
For your exercise assume:
(a) Minimum desired return of 10%.
(b) Rentals and repairs will arise on the last day of the year.
(c) Construction registration and other costs will be incurred at time ‘0’.
(d) The relevant discount factors are:
Year Discount factor

1-5 3.7908

6-10 2.3538
 11-15 1.4615

14 .26333

15 .23939

Ans: Lease rent per flat = 59,092 Approx.

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Q. 16A. N Ltd. is a hire purchase and leasing company. It has been approached by a small
business firm interested in acquiring a machine through leasing. The quoted price of the
machine is ` 5,00,000. 10% sale tax is extra. The lease will be for a primary lease period of
5 years.
The finance company wants 8% post-tax return on the outlay. Its effective tax rate is 35%.
The income tax rate of depreciation on the machine is 25% (WDV). Lease rents are payable
in arrear at the end of each year.
Calculate the annual rent to be charged by N Ltd.
PVF @ 8% Year 1 = .926; Year 2 = .857; Year 3 = .794; Year 4 = .735; Year 5 = .681; PVAF @
8% for 5 years = 3.993;
Ans: 1,64,795;
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Q. 17. A request has been received by Lotus Finance Ltd. who is engaged in leasing
business, for structuring a lease of a machine costing ` 30 lakhs. The average post-
tax cost of funds to Lotus Finance (effective tax rate 50%) is 10%, but they wish to
mark up this by 2% to cover the effects of inflation.
(a) The lease period is to be 5 years;
(b) The rents will be payable on the first day of each year; and
(c) The machine will be fully depreciated in 5 years.
Calculate lease rent to be charged by leasing company.
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Q. 18. A request has been received by Lotus Finance Ltd. who is engaged in leasing
business, for structuring a lease of a machine costing ` 30 lakhs. The average post-
tax cost of funds to Lotus Finance (effective tax rate 50%) is 10%, but they wish to
mark up this by 2% to cover the effects of inflation.
(a) The lease period is to be 5 years;
(b) The rents will be payable on the last day of each year; and
(c) The machine will be fully depreciated in 5 years.
Calculate lease rent to be charged by leasing company.
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Q. 19. FAIR finance, a leasing company, has been approached by a prospective customer
intending to acquire a machine whose cash down price is ` 3 Crores. The customer, in order
to leverage his tax position, has requested a quote for a three-year lease with 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%.
Required:
Calculate the lease rents to be quoted for the lease for three years.
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Q. 20. FAIR finance, a leasing company, has been approached by a prospective
customer intending to acquire a machine whose cash down price is ` 6 Crores. The
customer, in order to leverage his tax position, has requested a quote for a three-
year lease with 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 WDV basis at 25% and FAIR finance’s marginal
tax rate is 35%. The target rate of return for FAIR finance on the transaction is 10%.
Required:
Calculate the lease rents to be quoted for the lease for three years.
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CALCULATION OF LEASE RENT PAYABLE BY LESSEE TO MATCH WITH LOAN
OPTION
Q. 21. Beta ltd. is considering the acquisition of a personal computer costing ` 50,000. The
effective life of the computer is expected to be 5 years. The company plans to acquire the
same either by borrowing ` 50,000 from its bankers at 15% interest p.a. or on lease. The
company wishes to know the lease rentals to be paid annually, which match the loan option.
The following further information is prided to you:
(1) The principal amount of loan will be paid in five annual equal instalments.
(2) Interest, Lease rentals, principal repayment are to be paid on the last day of each year.
(3) 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 purpose.
(4) The company’s effective tax rate is 40% and the after-tax cost of capital is 9%.
(5) The computer will be sold for ` 1,700 at the end of the 5th year. The commission on such
sales is 9% on the sale value.
You are required to compute the annual lease rentals payable by beta ltd. which will result
in indifference to the loan option.
PVF @ 9%
1 2 3 4 5
.91743 .84168 .77218 .70843 .64993
PVAF @ 9% for 5 years = 3.8896;
Ans: PV of Cash outflows in loan = 33,839; Lease rental = 14,500;
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Q. 22. S Ltd. is faced with a decision to purchase or acquire on lease a mini car. The cost of
the mini car is `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% on the gross
value of the asset. S Limited can also obtain 100% finance from its regular banking channel.
The rate of interest will be 15% p.a. and the loan will be paid in five annual equal instalments,
inclusive of interest. The effective tax rate of the company is 40%. 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.

What should be the annual lease rental to be charged by the leasing company to match the
loan option? For your exercise use the following discount factors:
Discount rate Year 1 Year 2 Year 3 Year 4 Year 5
10% .91 .83 .75 .68 .62
15% .87 .76 .66 .57 .49
9% .92 .84 .77 .71 .65
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 SMART MIND
COMPARISON BETWEEN LEASED AND OWNED ASSET
Q. 1. The following details relate to an investment proposals of HI Ltd.
- Investment outlay Rs.180 lakhs
- Net salvage value after 3 years, ` 18 lakhs
- Annual rate of Depreciation 40%

HI Ltd. has two alternatives:

Option I: Borrow and buy the equipment @ 17% p.a, Marginal rate of Tax 35%;
Cost of capital of HI Ltd. 12%

Option II: Lease on 3 years full pay out basis@ ` 444/Rs.1000 payable annually in
arrears.
Which option HI Ltd. should choose any and why?

Ans:
Borrow to purchase option
PV of cash outflows
Particulars 1 2 3

Principal 60,00,000 60,00,000 60,00,000

Interest 30,60,000 20,40,000 10,20,000

Tax saving on interest (35%) (10,71,000) (7,14,000) (3,57,000)

Tax saving on depreciation (35%) (22,68,000) (9,07,200) (13,60,800)

Salvage value - - (18,00,000)

Cash outflows 57,21,000 64,18,800 35,02,200

PVIF@12% .893 .797 .712

PV of cash outflows 51,08,853 51,15,784 24,93,566

Total PV of cash outflows 1,27,18,203

Calculation of interest
Year Loan Interest

1 180,00,000 30,60,000

2 120,00,000 20,40,000

3 60,00,000 10,20,000
Calculation of depreciation
Year Opening WDV Depreciation Closing WDV
(40%)

1 180,00,000 72,00,000 108,00,000

2 108,00,000 43,20,000 64,80,000

3 64,80,000 25,92,000 38,88,000

Lease option
Particulars `

PV of lease rent 1,91,96,784

(444/1,000)*180,00,000*2.402

PV of tax saving on lease rent (1, 91, (67,18,874)

96,784*35%)

PV of cash outflows 1,24,77,910

Lease option should be selected due to lower PV of cash outflow.

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Q. 2. Excel engineers propose to expand its business with the help of installation of
a new machine costing ` 50 lakhs.
Proposal I: Buying
The machine may be bought at a cost of ` 50 lakhs @ 15% interest and loan to be
repaid in 5 equal instalments and interest on reducing value. Salvage value of
machine at the end of 5 years is estimated to be ` 6 lakhs. (Dismantling cost may be
ignored). Depreciation of the machine is 25% on written down value.
Proposal II: Lease
Annual lease rent to be paid ` 12 lakhs per year for next 5 years. Company’s tax rate
is 40%. Advise the company on which option is to be chosen.

Ans:
Amount of instalment = Amount of loan/PVIFA @ 15% for 5 years
= 50, 00,000/3.352 = 14, 91,647;

Calculation of principal and interest

Particulars 1 2 3 4 5

Opening balance 50,00,000 42,58,353 34,05,459 24,24,631 12,96,679

Interest@15% 7,50,000 6,38,753 5,10,819 3,63,695 1,94,968

Instalment 14,91,647 14,91,647 14,91,647 14,91,647 14,91,647

 Closing balance 42,58,353 34,05,459 24,24,631 12,96,679 Nil

Calculation of depreciation
Year Opening WDV Depreciation Closing WDV
(25%)

1 50,00,000 12,50,000 37,50,000

2 37,50,000 9,31,250 28,18,750

3 28,18,750 7,04,688 21,14,063

4 21,14,063 5,28,516 15,85,547

5 15,85,547 3,96,387 11,89,160

Cost of capital rate = 15*(1-.4) = 9%;

Borrow to purchase option

PV of cash outflows
Particulars 1 2 3 4 5

Instalment 14,91,647 14,91,647 14,91,647 14,91,647 14,91,647

Tax saving on (3,00,000) (2,55,501) (2,04,328) (1,45,478) (77,987)

interest (40%)

Tax saving on (5,00,000) (3,72,500) (2,81,875) (2,11,406) (1,58,555)

depreciation
(40%)

Salvage value - - - - (6,00,000)

Cash outflows 6,91,647 8,63,646 10,05,444 11,34,763 6,55,105

PVIF@9% 0.917431 0.84168 0.772183 0.708425 0.649931

PV of cash 6,34,539 7,26,913 7,76,387 8,03,895 4,25,773

outflows

Total PV of cash 33,67,507

outflows

Lease option
 Particulars `

PV of lease rent 12,00,000*3.8897 46,67,640

PV of tax saving on lease rent (40%) (18,67,056)

PV of cash outflows 28,00,584

Lease option should be selected due to lower PV of cash outflow.

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REPAYMENT OF BORROWED FUND IN EQUAL INSTALMENTS
Q. 3. XYZ ltd requires an equipment costing ` 10, 00,000; the same will be utilized
over a period of 5 years. It has two financing options in this regard:
(1) Arrangement of a loan of ` 10,00,000 at an interest rate of 13% per annum; the
loan being repayable in 5 equal year end instalments; the equipment can be sold at
the end of 5th year for ` 1,00,000.
(2) Leasing the equipment for a period of 5 years at an early rental of ` 3, 30,000
payable at the year end.
The rate of depreciation is 15% on written down value (WDV) basis, income tax rate
is 35% and discount rate is 12%.
Advise which of the financing options should XYZ ltd exercise and why?

Ans:
Amount of instalment = Amount of loan/PVIFA @ 13% for 5 years
= 10, 00,000/3.605 = 2, 77,393;

Calculation of principal and interest

Particulars 1 2 3 4 5

Opening balance 10,00,000 8,52,607 6,86,053 4,97,847 2,85,174

Interest@13% 1,30,000 1,10,839 89,187 64,720 7,781 (bal.)

Instalment 2,77,393 2,77,393 2,77,393 2,77,393 2,77,393

Closing balance 8,52,607 6,86,053 4,97,847 2,85,174 Nil

Calculation of depreciation
Year Opening WDV Depreciation Closing WDV
(15%)

1 10,00,000 1,50,000 8,50,000

2 8,50,000 1,27,500 7,22,500

 3 7,22,500 1,08,375 6,14,125

4 6,14,125 92,119 5,22,006

5 5,22,006 78,301 4,43,705

Borrow to purchase option

PV of cash outflows
Particulars 1 2 3 4 5

Instalment 2,77,393 2,77,393 2,77,393 2,77,393 2,77,393

Tax saving on (45,500) (38,794) (31,215) (22,652) (2,723)

interest (35%)

Tax saving on (52,500) (44,625) (37,931) (32,242) (27,405)

depreciation
(35%)

Salvage value - - - - (1,00,000)

Cash outflows 1,79,393 1,93,974 2,08,247 2,22,499 1,47,265

PVIF@12% .893 .797 .712 .636 .567

PV of cash 1,60,198 1,54,597 1,48,272 1,41,509 83,499

outflows

Total PV of cash 6,88,076

outflows

Lease option
Particulars `

PV of lease rent 3,30,000*3.605 11,89,650

PV of tax saving on lease rent (35%) 4,16,378

PV of cash outflows 7,73,273

Borrow to purchase option is better due to lower PV of cash outflows.

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Q. 4. M/s Gama & company 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 & company can raise debt at 14% payable in five equal
annual instalments of ` 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 ` 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.
PV factors 0.9225, 0.8510, 0.7851, 0.7242, and 0.6681 respectively for 1 to 5 years.

Ans:
Equal annual instalment = Amount of loan/PVIFA @ 14%
1, 78,858 = Amount of loan/3.91371
Amount of loan = 6, 99,998;

Cost of capital rate = 14*(1-.4) = 8.4%

Calculation of principal and interest

Particulars 0 1 2 3 4

Opening balance 6,99,998 5,21,140 4,15,242 2,94,518 1,56,893

Interest@14% 0 72,960 58,134 41,233 21,965(bal.)

Instalment 1,78,858 1,78,858 1,78,858 1,78,858 1,78,858

Closing balance 5,21,140 4,15,242 2,94,518 1,56,893 Nil

Depreciation = (6, 99,998-24,998)/5 = 1, 35,000;

Borrow to purchase option

PV of cash outflows
Particulars 0 1 2 3 4 5

Instalment 1,78,858 1,78,858 1,78,858 1,78,858 1,78,858 0

Tax saving on 0 (29,184) (23,254) (16,493) (8,786) 0

interest
(40%)

Tax saving on 0 (54,000) (54,000) (54,000) (54,000) (54,000)

depreciation
(40%)
 Salvage value - - - - - (24,998)

Cash outflows 1,78,858 95,674 1,01,604 1,08,365 1,16,072 (78,998)

PVIF@8.4% 1 .9225 .8510 .7851 .7242 .6681

PV of cash 1,78,858 88,259 86,456 85,077 84,059 (52,778)

outflows

Total PV of 4,69,931
cash outflows

Lease option
Lease rent = 6, 99,998*25% = 1, 75,000
Particulars `

PV of lease rent 1,75,000*3.5909 6,91,408

PV of tax saving on lease rent (40%) 2,76,563

PV of cash outflows 4,14,845

Lease option is better due to lower PV of cash outflows.

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Q. 5. Find out Loan payments per annum for the following:
Cost of Equipment: ` 50 lakhs
Borrowing rate: 15%
Term of Loan: 5 years
a. Principal is payable in equal investment over the period of five years.
b. Amount of Loan is payable equally over the period of five years.
Prepare a table showing principle & interest payments and the total payable over
period of five years.

Ans:
(a) Calculation of principal and interest
Year Opening Interest @ 15% Principal Total payment
balance payment
1 50,00,000 7,50,000 10,00,000 17,50,000

2 40,00,000 6,00,000 10,00,000 16,00,000

3 30,00,000 4,50,000 10,00,000 14,50,000

4 20,00,000 3,00,000 10,00,000 13,00,000

5 10,00,000 1,50,000 10,00,000 11,50,000

(b) Amount of instalment = Amount of loan/PVIFA @ 15% for 5 years
= 50, 00,000/3.352 = 13, 86,963;

Calculation of principal and interest

Particulars 1 2 3 4 5

Opening 50,00,000 42,58,353 34,05,459 24,24,631 12,96,679

balance

Interest@15% 7,50,000 6,38,753 5,10,819 3,63,695 1,94,968 (bal.)

Instalment 14,91,647 14,91,647 14,91,647 14,91,647 14,91,647

Closing balance 42,58,353 34,05,459 24,24,631 12,96,679 Nil

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Q. 6. ABC ltd is considering a proposal to acquire a machine costing ` 1,10,000
payable ` 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 ` 15,000 per annum payable at the end of
each year for 10 years. The following information is also available:
(1) Terminal scrap value of ` 20,000 are realizable, if the asset is purchased.
(2) The company provides 10% depreciation on straight line method on the original
cost.
(3) Income tax rate is 50%.
Required:
Compute the analyze cash flows and to advise as to which option is better.

Ans: Borrow to purchase option

Annual equal instalment = Amount of loan/PVIFA @ 15%
=1, 00,000/5.019 = 19,924;

Calculation of principal and interest

Particula 1 2 3 4 5 6 7 8 9 10
rs

Opening 1,00, 95,0 89,4 82,9 75,4 66,8 56,8 45,5 32,4 17,3
balance 000 76 13 01 12 00 96 06 08 45

Interest 15,0 14,2 13,4 12,4 11,3 10,0 8,53 6,82 4,86 2,57
@15% 00 61 12 35 12 20 4 6 1 9

Instalme (19,9 (19, (19, (19, (19, (19, (19, (19, (19, (19,
nt 24) 924) 924) 924) 924) 924) 924) 924) 924) 924)
 Closing 95,0 89,4 82,9 75,4 66,8 56,8 45,5 32,4 17,3 nil
balance 76 13 01 12 00 96 06 08 45

Calculation of depreciation = 1, 10,000*10% = 11,000

Cost of capital rate = 15*(1-.5) = 7.5%

PV of cash outflows
Particul 0 1 2 3 4 5 6 7 8 9 10
ars

Instalm 10, 19,9 19,9 19,9 19,9 19,9 19,9 19,9 19,9 19,9 19,9
ent 000 24 24 24 24 24 24 24 24 24 24

Tax 0 (7,5 (7,1 (6,7 (6,2 (5,6 (5,0 (4,2 (3,4 (2,4 (1,29
saving 00) 31) 06) 18) 56) 10) 67) 13) 31) 0)
on
interest
(50%)

Tax 0 (5,5 (5,5 (5,5 (5,5 (5,5 (5,5 (5,5 (5,5 (5,5 (5,50
saving 00) 00) 00) 00) 00) 00) 00) 00) 00) 0)
on
depreci
ation
(50%)

Salvag - - - - - - - - - - (20,0
e value 00)

Cash 10, 6,92 7,29 7,71 8,20 8,76 9,41 10,1 11,0 11,9 (6,86
outflow 000 4 3 8 6 8 4 57 11 93 6)

PVIF@ 1 .930 .865 .805 .749 .697 .648 .603 .561 .522 .486
7.5%

PV of 10, 6,43 6,30 6,21 6,14 6,11 6,10 6,12 6,17 6,26 (3,33
cash 000 9 8 3 6 1 0 5 7 0 7)
outflow

Total 52,544
PV of
cash
outflow
Lease option
Particulars `

PV of lease rent 15,000*6.866 1,02,990

PV of tax saving on lease rent (50%) 51,495

PV of cash outflows 51,495

Lease option is better.

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