Hire Purchase and Leasing

Problems:

1. KK Industries limited plans to acquire automated assembly line equipment with a five-
year life at a cost of Rs. 55 millions. The company can borrow the required rate and Rs.
55 million at a interest rate of 10 percent per annum. The equipment is expected to have a
scrap value of zero after five years of use.
The company can lease the equipment for five years at a rental charge of Rs. 12 million
payable at the beginning of each year. The lease contract stipulates that the lessor will
maintain the equipment at no additional charge to the company. However, if the company
borrows and buys, it will have to bear the cost of maintenance, which will be done by the
equipment manufacturer at a fixed contract rate of Rs. 0.25 million per year, payable at
the beginning of each year. The company’s tax rate is 30 per cent. Advise the company
on acquiring the equipment.
Solution:

Sl. Amount (Rs. In million)

Particulars
No. Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
  LOAN            
1 Interest Payment (after tax)   (3.85) (3.85) (3.85) (3.85) (3.85)
2 Maintenance cost (0.25) (0.25) (0.25) (0.25) (0.25)  
3 Loan Repayment           (55)
Tax savings on Maintenance
4 cost 0.075 0.075 0.075 0.075 0.075  
5 Tax shield on Depreciation   3.3 3.3 3.3 3.3 3.3
6 Net Cash Flows (0.175) (0.725) (0.725) (0.725) (0.725) (55.55)
PV @ 7% (after tax cost of
7 debt) 1 0.935 0.873 0.816 0.763 0.713
(0.6776 (0.5531
8 PV of Cash Flows (0.175) ) (0.6332) (0.5918) ) (39.6064)
               
  LEASE FINANCING            
1 Lease Rental (12) (12) (12) (12) (12)  
2 Tax savings on Lease Rental 3.6 3.6 3.6 3.6 3.6  
3 Net Cash Flows (8.4) (8.4) (8.4) (8.4) (8.4)  
PV @ 7% (after tax cost of
4 debt) 1 0.935 0.873 0.816 0.763  
(7.8505 (6.4083
5 PV of Cash Flows (8.4) ) (7.3369) (6.8569) )  

Note:
i. After tax loan Interest Repayment = 5.5 (1-0.3) = 3.85
ii. Tax savings on Maintenance cost = 0.25*0.3 = 0.075
 iii. Depreciation = 55/5 = 11
iv. Tax shield on Depreciation = 11*0.3 = 3.3
LOAN
Present Value of Cash Outflow = 42.24 million
LEASE FINANCING
Present Value of Cash Outflow = 36.85 million
Net advantage of Leasing over Loan = 42.24 - 36.85 = 5.39 million

2. Royal Industries Ltd. Is considering investment in equipment, the details of which are as
follows:
The equipment costs Rs. 30 million and is expected to have a five-year effective life with
zero salvage value. The company follows the straight-line method of depreciation. The
company can buy the equipment through a term loan and its own funds in the ratio 2:1.
The loan carries a simple rate of interest of 10 per cent and is repayable in five equal
annual instalments. The equipment is expected to generate an incremental EBDIT
(earnings before depreciation, interest and tax) of Rs. 20 million per year. The company
has received an offer from a leasing company. The offer details are as follows:
Primary Lease Period: 5 years
Management fee: 0.5 per cent of cost of equipment
Annual lease rentals: Rs. 300/ Rs. 1000
The lease rentals are payable annually in arrears but the management fee is payable
immediately on signing the lease. The corporate tax rate is 30 per cent and the marginal
cost of capital for Royal Industries is 12 per cent. Which alternative is better for the
company?

3. Evergreen Pvt. Ltd. is considering the possibility of purchasing a multipurpose machine

which cost Rs. 10.00 lakhs. The machine has an expected life of 5 years. The machine
generates Rs. 6.00 lakhs per year before Depreciation and Tax, and the Management
wishes to dispose the machine at the end of 5 th year which will fetch Rs. 1.00 lakh. The
Depreciation allowable for the machine is 25% on written down value and the
Company’s Tax rate is 50%. The company approached a NBFC for a five year Lease for
financing the asset which quoted a rate of Rs. 28 thousand per month. The Company
wants you to evaluate the proposal with purchase option. The cost of capital is 12% and
for lease option it wants you to consider a discount rate of 16%. (SEE 2017 Dec./Jan.)
Solution:

Rs. In Lakh
Cash Inflows
 PV of EAT 10.815
(Before Depr.)

Add: PV of Tax 1.81

Shield on Depr
12.625
PV of EAT 12.625
(Before Depr.)

Cash Outflows 10

Benefit 2.625

4. The hypothetical leasing limited has a lease proposal under consideration. Its post-tax
cost of funds is 14% and it has to pay central sales tax (CST) @10% of the basic price of
the capital equipment on inter-state purchases.
The marginal tax rate of HLL is 35%. The detail of the proposed lease are given below:
→ Primary lease period 3 years
→ Tax relevant depreciation, 40% on WDV basis with other assets in the bank.
→ Residual value 8% of the original cost.
i. If the monthly lease rentals are collected in advance, what is the minimum lease
rental the HIL should charge for per Rs. 1000 for the lease?
ii. What is the minimum monthly lease proposal costing Rs. 660 lakh (including
CST at 10%)? (SEE 2015 Dec.)

5. ABC Ltd is in the business of manufacturing auto components. Some more product lines
are being planned to be added to the existing sytem. The machinery required may be
bought or may be taken on lease. The cost of machine is Rs.4000000 having a useful life
of 5 years with the salvage value of Rs.800000. The machine can be financed at 20% loan
repayable in five equal installments. Alternatively the machine can be procured on a lease
rental of Rs.1200000 per annum. The company follows the written down value method of
depreciation at the rate of 25%. Its tax rate is 35% and cost of capital is 16%. Advise the
company which option it should choose. (SEE 2017 Dec./Jan.)
Solution:

Depreciation Calculation
Year 1 2 3 4 5
Value at the Beginning 40 32 25.6 20.48 16.384
Depreciation 8 6.4 5.12 4.096 3.2768
Value at the end 32 25.6 20.48 16.38 13.1072
4
Tax Shield on Depreciation 2.8 2.24 1.792 1.433 1.14688
6

Sl.  
No Particulars Year Year Year Total
Year 4 Year 5
. 1 2 3
  Loan Option          
1 Interest Payment (after tax) -5.2 -5.2 -5.2 -5.2 -5.2
2 Loan Repayment         -40
3 Tax shield on Depreciation 2.8 2.24 1.79 1.43 1.15
4 Salvage value 8
5 Net Cash Flows -2.4 -2.96 -3.41 -3.77 -44.05
6 PV @ 16% 0.862 0.743 0.641 0.552 0.476
-
7 PV of Cash Flows 2.069 -2.199 -2.184 -2.082 -20.972 -29.508
 ………………………………………………………………..06 marks for 1a
  LEASE FINANCING          
1 Lease Rental -12 -12 -12 -12 -12
2 Tax savings on Lease Rental 4.2 4.2 4.2 4.2 4.2
3 Net Cash Flows -7.8 -7.8 -7.8 -7.8 -7.8
4 PV @ 16% 0.862 0.743 0.641 0.552 0.476
5 PV of Cash Flows -6.72 -5.79 -4.99 -4.307 -3.71 -25.539

After tax loan Interest Repayment = 8(1-0.35) = 5.2

Loan Option:
Present Value of Cash Outflow = 29.51 Lakh
Lease Financing Option = Present Value of Cash Outflow = 25.54 Lakh
Net advantage of Leasing over Instalment purchase = 29.51 - 25.54 = 3.97 Lakh

Solution:

Depreciation Calculation
Year 1 2 3 4 5
Value at the Beginning 40 32 25.6 20.48 16.384
Depreciation 8 6.4 5.12 4.096 3.2768
Value at the end 32 25.6 20.48 16.384 13.1072
 Tax Shield on Depreciation 2.8 2.24 1.792 1.4336 1.14688

Sl.  
Particulars Total
No. Year 1 Year 2 Year 3 Year 4 Year 5
  Loan Option          
1 Interest Payment (after tax) -5.2 -5.2 -5.2 -5.2 -5.2
3 Loan Repayament         -40
5 Tax shield on Depreciation 2.8 2.24 1.79 1.43 1.15
Salvage value 8
6 Net Cash Flows -2.4 -2.96 -3.41 -3.77 -44.05
7 PV @ 16% 0.862 0.743 0.641 0.552 0.476
8 PV of Cash Flows -2.0690 -2.1998 -2.184 -2.0821 -20.972 -29.508
             
  LEASE FINANCING          
1 Lease Rental -12 -12 -12 -12 -12
2 Tax savings on Lease Rental 4.2 4.2 4.2 4.2 4.2
3 Net Cash Flows -7.8 -7.8 -7.8 -7.8 -7.8
4 PV @ 16% 0.862 0.743 0.641 0.552 0.476
5 PV of Cash Flows -6.7241 -5.7967 -4.9971 -4.3079 -3.7137 -25.539