LEASING DECISIONS

LEASING

1. Lease v/s Buy

2. Lease v/s Loan

3. NPV from the point of view of lessor

4. Break Even lease Rental

1. Lease v/s Buy

Whenever any asset is to be acquired, then decision is taken whether such asset
should be bought or should be taken on lease.

Such decision is taken on the basis of lower present value of Cash outflows.

Format – Statement showing PVCO

Year PVF Amount P.V.

Option 1. Lease option
Lease Rent 1-5 XXX XXX. XXX
Tax saving on lease Rent 1-5 XXX XXX. (XXX)
PVCO XXX
Option 2. Buy option
Purchase Cost 0 XX XXX XXX
Tax Saving on Dep. 1-5 XX (XX) (XXX)
Terminal Value 5 XX (XX) (XXX)
PVCO XXX

Lower PVCO Should be accepted.

Important Note

1. If lease Rent includes Maintenance Expenses then Maintenance Exp. Shall

not be considered in Lease option but it should considered in Buy option.
[Borne by lesser]

2. If Maintenance Exp. Does not include in lease Rent means maintenance

exp. Are borne by lessee, then it should not be considered.

Eg.1

Cost of machine : ₹ 4,50,000

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 LEASING DECISIONS

Life : 5 year

Salvage : ₹ 50,000

Dep. : SLM

Lease period : 5 Years

Lease Rent : ₹ 1,25,000 P.a.

Tax = 30% Cost of Capital = 10%

Which option is better Lease v/s Buy

Solution:

W.N. 1 Tax Saving on Depreciation

4,50,000-50,000
Depreciation = = 80,000
5

Tax Savings = 80000 × 30% = 24,000

Statement Showing Calculation of PVCO

Year PVF (10%) Amount P.V.

Option 1. Lease option
Lease Rent (Net of Tax) 1-5 3.791 87,500 3,31,712
1,25,000 (1-0.30)
PVCO 3,31,712
Option 2. Buy option
Purchase Price 0 1.000 4,50,000 4,50,000
Tax Saving on Dep.(W.N.1) 1-5 3.791 (24,000) (90,984)
Terminal Value 5 0.621 (50,000) (31,050)
PVCO 3,27,966

Buy option is better due to lower PVCO

Eg.2

Cost of machine : ₹ 4,25,000

Life : 4 year

Salvage : ₹ 25,000

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 LEASING DECISIONS

Dep. : 20% P.a. WDV Method

Lease

Lease Rent : 1,50,000 P.a. payable at the beginning of each year.

Period : 4 years

Tax = 40% Coc = 12%

Solution:

W.N. 1 Tax Saving on Depreciation

Year Dep. (4,25,000) Tax Saving (40%) PVF (12%) P.V.

1 85,000 34,000 0.893 30,362

2 68,000 27,200 0.797 21,678

3 54,400 21,760 0.712 15,493

4 43,520 17,408 0.636 11,071

78,605

P.V. of tax Saving on Depreciation

Statement Showing Calculation of PVCO

Year PVF (12%) Amount P.V.

Option 1. Lease option
Lease Rent 0-3 3.402 1,50,000 5,10,300
Tax Saving on Lease Rent 1-4 3.037 (60,000) (1,82,220)
(1,50,000 × 40%)
PVCO 3,28,080
Option 2. Buy option
Purchase Price 0 1.000 4,25,000 4,25,000
Tax Saving on Dep. (W.N.1) - - (78,605)
Terminal Value 4 0.636 (25,000) (15,900)
PVCO 3,30,495

Lease option is better due to lower PVCO

It is assumed that there is no capital Gain Tax

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 LEASING DECISIONS

→ If Lease Rent is paid in advance i.e. beginning of each year, than Tax Savings on
Lease Rent shall be considered at the end of ear year.

2. Lease v/s Loan

Statement showing Calculation PVCO

Year PVF Amount P.V.

Option 1. Lease option
Lease Rent (Net of Tax) xx xx xx xx

PVCO xx
Option 2. Loan option
installments paid Including Interest 1-5 xx xx xx
Tax Saving on Interest 1-5 xx (xx) (xx)
Tax Saving on Dep 1-5 xx (xx) (xx)
5 xx (xx) (xx)
PVCO xx

Eg.3

Cost of machine : ₹ 90,000

Life : 3 year

Salvage : ₹ 15,000

Dep. : SLM

Lease option → : Borrow ₹ 90,000 @ 10% p.a. Repayable 3 equal Installments

Including interest.

Which option is better lease or Buy.

Lease option → Lease Rent ₹ 40,000 P.a.

Tax = 30%

Solution:

W.N. 2 Tax Saving on interest & Dep.

Year Installments Intt. (10%) Principal Out Standing Balance

1 36,188 9,000 27,188 62,812

2 36,188 6,281 29,907 32,905

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3 36,188 3,283 32,905 -

Year Installments Dep Total Tax Saving (30%)

1 9,000 25,000 34,000 10,200

2 6,281 25,000 31,281 9,384

3 3,283 25,000 28,283 8,485

Statement showing Calculation PVCO

Year PVF 7% Amount P.V.

Option 1. Lease option
Lease Rent (Net of Tax) 1-3 2.624 28,000 73,472
PVCO 73,472
Option 2. Loan option
installments Including Intt (W.N.1) 1-3 2.624 36,188 94,957
Tax Saving on Intt. & Dep (W.N.2) 1 0.934 (10,200) (9,527)
Tax Saving on Dep 2 0.873 (9,384) (8,192)
3 0.816 (8,485) (6,924)
Salvage 3 0.816 (1,500) (12,240)
58,074

Loan option is better due to Lower PVCO

Note :- If discounting rate in not given in question then Cost of debt (kd)
should
kd = 10 (1- 0.30) be
= 7used.
kd = I (1-t)

3. from the point of view of lesser

Statement showing Calculation of PVCO

Year PVF Amount P.V.

(A) Cash outflows.
Purchase Cast 0 1.000 xx xx
Tax Saving on Dep. 1-5 xx (xx) (xx)
Salvage valve 5 xx (xx) (xx)
PVCO (A) xx
(B) Cash Inflows.
Lease Rent (Net of Tax) (B) 1-5 xx xx xx
xx
NPV (B-A) xxx

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04 - LEASING
Question 1
H L Manufacturing Ltd. desires to acquire a diesel generating machine set costing ₹ 40
lakh which has an economic life of 10 years at the end of which the asset is not
expected to have any residual value. The company is considering two alternatives:

(a) taking the machine on lease

(b) purchasing the asset outright by raising a loan.

Lease payments are equal annual amounts and have to be made in advance and the
lessor requires the asset to be completely amortized over its useful period. The loan
carries an interest 16% p.a. The loan has to be paid in 10 equal annual installment
becoming due at the beginning of the first year. Average rate of income tax is 50%. It is
expected that the operating costs would remain the same under either method. The
company allows straight line method of depreciation and the same is accepted for tax
purposes.

Assume tax benefits at the end of the respective years and for end of year zero, tax
benefit may be considered at the end of the first year. Use 8% discount rate for p.v.
factors. Present a statement showing discounted values of annual cash flows to the
nearest rupee under alternative (b), only for end of years 0 to 2 and year 10. What
should be the maximum annual lease rental for which the lease option may be
preferred if you are given that the present value under the loan option is ₹ 26,57,029?
The present value of an annuity of one Rupee.

Year 1 8%
1 to 9 6.247
1 to 10 6.7

Present value of Rupee one at 8%

Year 0 1 2 3 4 5 6 7 8 9 10
PV 1.00 0.926 0.857 0.794 0.735 0.681 0.630 0.583 0.540 0.500 0.463

(Marks 8)
(Exam, Dec – 2017)

Solution:

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Question 2
XYZ Ltd. is considering acquisition of an additional computer to supplement its
computer services to its clients. It has two options:

(i) To purchase the computer for ₹ 22,00,000

(ii) To lease the computer for 3 year from a leasing company for ₹ 5,00,000
as annual year end lease rent. The agreement also requires as additional
one time lump sum lease rent payment of ₹ 6,00,000 at the end of the
third year. Lease rents are payable at the year ends and the computer is
returned to the lessor after the lease period.

The company estimates that the computer considered for purchase now will be
worth ₹ 10 lakhs at the end of the third year and proceeds are taxable at the
end of the third year at the usual 50% tax rates. Forecast pre-tax year end
revenues are:

Year ₹

1 22,50,000

2 25,00,000

3 27,50,000

Annual year end pre-tax operating costs (excluding depreciation/lease rent of

computer) are estimated at ₹ 9,00,000 with an additional ₹ 1,00,000 for start-
up and training costs at the beginning of the first year, the tax benefit of which
can be claimed at the end of the first year. These costs are to be borne by XYZ
Ltd. will borrow at 16% interest to finance the acquisition of the computer and
the repayments are to be made according to the following schedule:

Year-end Principal (₹) Interest (₹) Total (₹)

1 5,00,000 3,52,000 8,52,000
2 8,50,000 2,72,000 11,22,000
3 8,50,000 1,36,000 9,86,000

The company depreciates the computer at 60% of cost in the first year and the
remaining at the end of the second year. Consider these at year ends. The
Management of XYZ Ltd. approaches you, as a Management Accountant, for
advice. why? Support your advice with relevant calculations. Present annual
discounted cash flows to the nearest rupee, for each option using PV factors up
to the decimals provided. Indicate inflows by ‘-’ or ‘( )’

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Note: Present value factor at 8% and 16% rate of discount:

Year 1 2 3
8% 0.926 0.857 0.794
16% 0.862 0.743 0.641
(Marks 10)
(Exam, June – 2018)
Solution:

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Question 3
A contract has been made between M & T Construction Company Ltd. and a
foreign embassy to build a block of ten flats to be used by the foreign embassy
as guest houses. As per the terms of the contract the foreign embassy would
provide the plans and the land costing ₹ 50 lakh to M & T Construction
Company Ltd. The Company would build their flats at their own cost and lease
them to the foreign embassy for 15 years. As per the contract the flats will be
transferred to the foreign embassy after 15 years at a nominal value of ₹ 16
lakh. The company estimates the cost of construction as follows:

Area per flat 1500 sq. feet

Construction cost ₹ 1200 per sq.
feet Registration and other costs 5% of cost of construction

The company will also incur ₹ 8 lakh each in years 14 and 15 towards repairs
of flats. M & T Construction Company Ltd. proposes to charge the lease rentals
as follows:

Years Rentals
1-5 Normal
6-10 130% of the normal
11-15 150% of normal

The company's present tax rate averages at 35% which is likely to be the same
in future. The full construction and registration costs will be written off over 15
years at a uniform rate and will be allowed for tax purposes.

Additional information:

(a) Minimum desired rate of return 10%

(b) Rentals and Repairs will arise on the last day of the year and

(c) construction, registration and other costs will be incurred at the

beginning of the project (t=0). Calculate the normal lease rent per annum
per flat.

(Marks 12)
(Exam, Dec – 2017)

Solution:

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Question 4
DF, a leasing company has agreed to lease an equipment to its customer for 4 years,
which is also the life of the equipment. The equipment costs ` 300 lacs, has no salvage
value and can be depreciated in 4 years on straight line basis. The customer has
requested that lease rentals be paid at the beginning of the first and second years and
at the end of the third and fourth years in the ratio 2:2:1:1 so that it can match its
own cash availability. DF's tax rate is 35%. Its target rate of return is 12% p.a. for this
lease. Calculate the lease rentals payable by the customer for each year. Use the
present value factors up to 3 decimal places only, as given in the table. Round off the
cash flows to the nearest rupee. Present your calculations showing the P.V. of the
cumulative depreciation shield, P.V. factors applied to cash inflows each year and
arrive at the lease rentals.

(Marks 10)

(Exam Dec – 2016)

Solution:

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Question 5
Lotus Finance Ltd. is engaged in leasing business. The company wants your
advice to structure the lease of a machine costing ₹ 30 lacs. The machine will
have no salvage value. The life of the machine and the lease period will be 5
years and it has to be fully depreciated in 5 years on straight line basis. The
average post-tax cost of funds to Lotus Finance is 10%, but to cover the effects
of inflation, they prefer to hike this rate by 2%. Assume tax rate is 50% and
that taxes are paid on the last day of the year.

Calculate the minimum annual lease rent to be charged if

(i) the lease rents are payable on the first day of each year.

(ii) the lease rents are payable on the last day of each year;

(iii) What is the type of the above lease? Give reasons for your classification.

(Marks 10)

(Exam Dec – 2015)

Solution:

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Question 6
R Ltd., a profitable company is considering the purchase of a new machine for
₹ 75,00,000. The machine’s useful life is 5 years, with annual maintenance,
insurance and administration costs of ₹ 12 lacs. Depreciation is over its life on
straight line basis, considering zero scrap value. The tax rate is 30%. R Ltd.
has a capital structure of 60% debt and 40% equity. Cost of debt before tax is
8% and the cost of equity is 12%. R Ltd. is interested in leasing out this
machine to a lessee ‘L’ on year end annual lease rents and R will have to
maintain the equipment at the costs stated above. What should be the lease
rents to be billed to ‘L’ for the lease proposal to break-even if:

(i) R Ltd. acquires the machine from its total finance pool.

(ii) R Ltd. uses a bank borrowing specifically for this purpose at 10% interest
rate on outstanding principal at the beginning of each year, with year-
end installments comprising ₹15 lacs towards principal and balance
towards interest for the year?

Present calculations to the nearest rupee.

(Marks 10)

(Exam Dec – 2019)

Solution:

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Question 7
A company wishes to acquire an asset costing Rs. 1,00,000. The company has
an offer from a bank to lend @ 18%. The principal amount is repayable in equal
5 year end installments. A leasing company has also submitted a proposal to
the company to acquire the asset on lease at year end rentals of Rs. 280 per
Rs. 1,000 of the asset value for 5 years. The asset’s life is estimated at 5 years
with residual value of Rs. 10,000 and the cost net of residual value is
depreciated equally each year over its life. Assume that this is the only asset of
its class so that at the end of the 5th year there will be a capital gain or lss
with 20% tax effect when the asset is sold. The tax rate of the company is 50%.

For what minimum sale value of the asset at the end of the 5th year will the
decision to borrow and own the asset be preferred to leasing ? Present annual
cash flows and arrive at the discounted cash flows for each year showing
salvage value separately. Use PV factors as provided. Round off calculations to
the nearest rupee. Assume cash flows on interest and taxes also at year ends.

(Marks 8)

(Exam Dec – 2018)

Solution:

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Question 8
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.

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.)

(Marks 8)

(Exam Dec – 2017)

Solution:

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Question 9
Precision Instruments Limited manufactures 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 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% interest per
annum repayable in five equal installments falling due at the end of each year.
Alternatively, the machine can be procured on a 5 year lease, year-end lease
rentals being ₹ 12.50 lakhs per annum. The company follows the written down
value method of depreciation at the rate of 25 per cent. The company is in 30%
tax bracket.

Required :
(i) What is the present value (PV) of cash outflow for each of these financing
alternatives using the after-tax cost of debt?
(ii) Which of the two alternatives is preferable?
Note : Extracts from the PV TABLE :
(i) PVIF at 7% for 0 to 5 years are : 1.000, 0.9346, 0.8734, 0.8163,
0.7629, 0.7130
(ii) PVIF at 10% for 0 to 5 years are : 1.000, 0.9091, 0.8264, 0.7513,
0.6830, 0.6209
(iii) PVIFA for 5 years at 10% = 3.7908
(iv) PVIFA for 5 years at 7% = 4.100
(Marks 10)
(Exam, Dec – 2012)
Solution:

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Question 10
KJ Hospital wants to install attesting equipment. It wants to analyze whether
to purchase the machine from a bank borrowing or to lease it from LR. The
following information is given:

(i) Cost of the equipment ₹ 50 lacs to be paid at the beginning of

the 1st year
Life 5 years
(ii) Residual value ₹ 5 lacs at the end of the 5th year
(iv) Depreciation Cost less residual value, written off equally p.a.
for the life of the asset
Annual Lease Rent ₹ 12 lacs Payable at the end of each
year from year 1 to year 5
(vi) If asset is purchased, 10% interest per Year-end payment includes
bank loan available at annum ₹10 lacs each year towards
principal and additionally,
interest on the balance
outstanding at the beginning
of the year.

(vii) Annual maintenance ₹ 2 lacs per payable at the end of each

charges to be annum year
incurred by KJ if the
equipment is
purchased

(viii) Tax rate applicable for 40% Assume KJ and LR are

KJ and LR profitable

(ix) After-tax weighted 12% p.a. For both LR and KJ

average cost of capital

(x) Long term capital 20% LR (For sale value in excess

gains tax of the residual value)

The lessor LR is an investor company that specializes in the leasing of various

medical equipments across the country. LR would buy the equipment from its
own funds, maintain the machine incurring ` 1 lac p.a. (year end). LR is
confident of reworking the equipment at the end of 5 years at no extra cost and
finding a rural hospital which would pay ₹ 13 lacs for it at the end of the 5th
year. However, for its depreciation, it would write off equal amounts each year
considering (i) to (iv) as for KJ. The lessor is also a profit-making company with
a 40% corporate tax rate and 20% tax rate on long term capital gains.

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(a) For KJ, present statements of discounted cash flows under the options of
buying the machine with borrowed funds and leasing, using the
appropriate discount rate. Present year wise annual cash flows (in ₹ lacs,
up to two decimal places), without netting off, arrive at the sub totals of
pre-discounted cash flows for each year and then apply PV factors (up to
three decimals as given) and then arrive at the total present value Use ‘+’
for inflows and ‘- or ( )’ for outflows.

(b) Evaluate the viability of the proposal for the lessor LR. Comment on the
situation.

(Marks 10)
(Exam, Dec – 2019)
Solution:

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Question 11
Nava Ratna Ltd. has just installed MACHINE R at a cost of ₹ 2,00,000. This machine
has 5 years life with no residual value. The annual volume of production is estimated
at 1,50,000 units, which can be sold at ₹ 6 per unit. Annual operating costs are
estimated at ₹ 2,00,000 (excluding depreciation) at this output level. Fixed costs are
estimated at ₹ 3 per unit for the same level of production.

The company has just come across another model called MACHINE S, capable of
giving the same output at an annual operating costs of ₹1,80,000 (excluding
depreciation). There will be no change in fixed costs. Capital cost of this machine is ₹
2,50,000 and the estimated life is 5 years with no residual value.

The company has an offer for sale of MACHINE R at ₹ 1,00,000. But the cost of
dismantling and removal will amount to ₹ 30,000. As the company has not yet
commenced operation, it wants to sell MACHINE R and purchase MACHINE S.

Nava Ratna Ltd. will be a zero-tax company for 7 years in view of several incentives
and allowances available. The cost of capital may be assumed as 14%.

Required:

(i) Advise the company whether it should opt for replacement.

(ii) What would be your advice, if MACHINE R has not been installed but the
company is in the process of selecting one or the other machine?

[Given: PVIF for 1-5 years = 0.877, 0.769, 0.675, 0.592, 0.519]
(Marks 20)
(Exam, Dec – 2013)

Solution:

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