Leasing

Q. Hypothetical Limited is contemplating having an access to a machine for a

period of 5 years Discussions with various financial institutions have shown that
the company can have the use of machine for the stipulated period through
leasing arrangement, or the requisite amount can be borrowed at 14 per cent to
buy the machine. The firm is in the 50 per cent tax bracket. In case of leasing, the
firm would be required to pay an annual end-of-year rent of `1,20,000 for 5
years. All maintenance, insurance and other costs are to be borne by the lessee.
In the case of purchase of the machine (which costs `3,43,300), the firm would
have a 14 per cent, 5-year loan, to be paid in 5 equal instalments, each
instalment becoming due at the end of each year. The machine would be
depreciated on a straight line basis for tax purposes, with no salvage value.
Advise the company regarding the option it should go for, assuming lease rentals
are paid (a) in advance (b)at the end of the year.
Q. The following details relate to an investment proposal of the
Hypothetical Industries Ltd (HIL): —
• Investment outlay, 180 lakh
• Useful life, 3 years
• Net salvage value after 3 years, 18 lakh
• Annual tax relevant rate of depreciation, 40 per cent
• The HIL has two alternatives to choose from to finance the
investment: Alternative I : Borrow and buy the equipment. The cost of
capital of the HIL, 0.12; marginal rate of tax, 0.35; cost of debt, 0.17
per annum.
. Alternative II : Lease the equipment from the Hypothetical
Leasing Ltd on a 3-year full-payout basis @ `444/`1,000
payable annually in arrear. The lease can be renewed for a
further period of 3 years at a rental of 18/1,000 payable
annually in arrear. Which alternative should the HIL choose?
Why?
• Consider the Debt- Displacement Debt Effect of Leasing-
• We are taking assumption or premise that Lease Finance displaces an
equal amount of long term debt.
• The interest tax shields on the displaced debt are also explicitly
considered.
• (In NAL method , we use of debt (not cost of capital )to find out PV of
lease rentals as we are finding the benefit of leasing instead of
borrowing . And the PV of Tax shield are arrived at by using the
opportunity cost of capital. And
• We also use the PV of leasing rentals as the amount that will be
borrowed.
Q. The following details relate to an investment proposal of the Hypothetical
Industries Ltd (HIL): —
• Investment outlay, 180 lakh
• Useful life, 3 years

• Net salvage value after 3 years, 18 lakh

• Annual tax relevant rate of depreciation, 40 per cent
• The HIL has two alternatives to choose from to finance the investment:
Alternative I : Borrow and buy the equipment. The cost of capital of the
HIL, 0.12; marginal rate of tax, 0.35; cost of debt, 0.17 per annum.
• Alternative II : assume the lease rental of `35/`1,000 payable monthly in
advance.
Compute the NAL(L). Should the HIL opt for the lease financing?