Financial Evaluation of Leasing M.F.S. CHAPTER – 4 M. Y. KHAN Financial Evaluation of Leasing

Net present Value of Leasing/Net Advantage of Leasing NPV(L)/NAL= Investment Cost Less: Present Value of Lease Payment (discounted by kd) Plus: Present Value of tax shield on Lease Payment (discounted by kc) Less: Management fee Plus: Present Value of tax shield on Management fee (discounted by kc) Minus: Present Value of depreciation shield (discounted by kc) Minus: Present Value of interest shield (discounted by kc) Minus: Present Value of residual/salvage value (discounted by kc) Where Kc = Post-tax marginal cost of capital Kd = Pre-tax cost of long-term debt

XYZ Ltd is in the business of manufacturing steel utensils XYZ Ltd is in the business of manufacturing steel utensils. The firm is planning to diversify and add a new product line. The firm either can buy the required machinery or get it on lease. The machine can be purchased for Rs 15,00,000. It is expected to have a useful life of 5 years with salvage value of Rs 1,00,000 after the expiry of 5 years. The purchase can be financed by 20 per cent loan repayable in 5 equal annual instalments (inclusive of interest) becoming due at the end of each year. Alternatively, the machine can be taken on year-end lease rentals of Rs 4,50,000 for 5 years. Advise the company, which option it should choose. For your exercise, you may assume the following: (i) The machine will constitute a separate block for depreciation purposes. The company follows written down value method of depreciation, the rate of depreciation being 25 per cent. (ii) Tax rate is 35 per cent and cost of capital is 18 per cent. (iii) Lease rents are to be paid at the end of the year.

PV of Cash Outflows Under Leasing Alternative Solution PV of Cash Outflows Under Leasing Alternative _______________________________________________________________________________________________ Year-end Lease rent PVIFA at Total PV after taxes 13% [R (1 – t)] [20%(1 – 0.35)] [Rs 4,50,000 (1 – 0.35)] 1-5 Rs 2,92,500 3.517 Rs 10,28,723

PV of Cash Outflows Under Buying Alternative _______________________________________________________________________________________________ Year Loan Tax advantage on Net cash PVIF Total -end instalment _____________________ outflows at PV Interest Depreciation (col. 2 – 13% (I ´ 0.35) (D ´ 0.35) col. 3 + col. 4) 1 2 3 4 5 6 7 1 Rs 5,01,505 Rs 1,05,000 Rs 1,31,250 Rs 2,65,255 0.885 Rs 2,34,751 2 5,01,505 90,895 98,437 3,12,173 0.783 2,44,431 3 5,01,505 73,968 73,828 3,53,709 0.693 2,45,120 4 5,01,505 53,656 55,371 3,92,478 0.613 2,40,589 5 5,01,505 29,114 41,528 4,30,863 0.543 2,33,959 11,98,850 Less: PV of salvage value (Rs 1,00,000 ´ 0.543) 54,300 Less: PV of tax savings on short-term capital loss: (Rs 3,55,958 – Rs 1,00,00) ´ 0.35 = (Rs 89,585 ´ 0.543) 48,645 NPV of cash outflows 10,95,905 * Equivalent annual loan instalment = Rs 15,00,000/2.991 (PVIFA for 5 years at 20% i.e. 20,5) = Rs 5,01,505. Recommendation: The company is advised to go for leasing as the PV of cash outflows under leasing option is lower than under buy/borrowing alternative.

Working Notes Schedule of Debt Payment _______________________________________________________________________________________________ Year-end Loan Loan at the Payments Loan instalment beginning ____________________________ outstanding of the year Interest Principal at the end (col. 3 ´ 0.20) repayment of the year (col. 2 – col. 4) (col. 3 – col. 5) 1 2 3 4 5 6 1 Rs 5,01,505 Rs 15,00,000 Rs 3,00,000 Rs 2,01,505 Rs 12,98,495 2 5,01,505 12,98,495 2,59,699 2,41,806 10,56,689 3 5,01,505 10,56,689 2,11,338 2,90,167 7,66,522 4 5,01,505 7,66,522 1,53,304 3,48,201 4,18,321 5 5,01,505 4,18,321 83,184* 4,18,321 — *Difference between loan instalment and loan outstanding. Schedule of Depreciation Year Depreciation Balance at the end of the year 1 Rs 15,00,000 x 0.25 = Rs 3,75,000 Rs 11,25,000 2 11,25,000 x 0.25 = 2,81,250 8,43,750 3 8,43,750 x 0.25 = 2,10,937 6,32,813 4 6,32,813 x 0.25 = 1,58,203 4,74,610 5 4,74,610 x 0.25 = 1,18,652 3,55,958