XYZ Ltd is in the business of manufacturing steel utensils.

The firm is planning to diversify

and add a new product line. The firm can either buy the required machinery or get it
on lease.
The machine can be purchased for $ 15,00,000. It is expected to have a useful life of
5 years with salvage value of $ 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 $ 4,50,000 for 5 years. Advise the
company on 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.
(iv) Maintenance expenses estimated at $ 30,000 per year are to be borne by the
lessee.
Solution:

PV OF CASH OUTFLOWS UNDER LEASING ALTERNATIVE:

YEAR END Lease rent after taxes (LR(1-t)] PVIFA at 13% Total PV

[$ 4,50,000 (1-.35)] [20%(1-.350]

1-5 years $ 2,92,500 3.517 $10,28,723

Borrowing /Buying Option

Equivalent annual loan installmen=$15,00,000/2.991 (PVIFA for 5 years at 20%)= $ 5,01,505

Schedule of Debt Payment

Year end Loan Installment Loan at the beginning Loan outstanding

of the year at the end of the
year (col. 3-col.5)
Interest Principle
(col.3 (Repayment)
*20%)
2 3 4 5 6
1 $ 5,01,505 15,00,000 300000 201505 1298495
2 $ 5,01,505 1298495 211338 241806 1056689
3 $ 5,01,505 1056689 212338 290167 768522
4 $ 5,01,505 766522 153304 348201 418321
5 $ 5,01,505 418321 83184 418321 -
Difference between loan installment and loan outstanding

Schedule of Depreciation
Year Dep Bal. at the end of the year
1 1500000*.25=375000 1125000
2 1125000*.25 843750
3 843750*.25 632813
4 632813*.25 474610
5 474610*.25 355958

PV of cash outflows under buying alternative

Year end Loan Loan at the Loan PVIF OX Total PV

Installment beginning of the outstanding at
year the end of the
year (col. 3-
col.5)
Interest Dep
(1*.35) (D*.35)
2 3 4 5 6 7
1 $ 5,01,505 105000 131250 265255 .855 234751
2 $ 5,01,505 90875 98437 312173 .783 244431
3 $ 5,01,505 73968 73828 353709 .693 245120
4 $ 5,01,505 53656 55371 392478 .613 240589
5 $ 5,01,505 29114 41528 430863 .543 233959
Total 11,98,850

Less PV of salcage value(100000*.543)= 54300

Less PV of tax savings on short term capital loss (355958-100000)*.35= 48645

NPV of cash outflows 10,95,905

Hence the company shall go with leasing.

2. ABC Company Ltd., has two financial options in respect of procuring an Equipment
for utilizing the same for 5 years costing Rs. 10,00,000. The two options are:
Option 1: Borrow Rs. 10,00,000 at an interest rate of 15%. The loan is repayable at 5
year end instalments. The equipment could be sold at the end of its 5 year economic life
at a realisable value of Rs. 1,00,000.
Option 2: lease in the asset for a period of 5 years at yearly rental of Rs. 3,30,000
payable at year end. The rate of depreciation allowable on the equipment is 15%. The
company has to pay Income Tax @ 50% and has a discounting rate of 16%. Capital gain
or loss is to be ignored. Evaluate the two options and give your opinion.
(Hint: purchase option: Rs. 5,78,164 and Lease option: Rs. 5,40,210)
Solution:
The two options before the company can be evaluated as follows:
Option IPurchase of equipment out of borrowed funds. In this case the company shall
have to pay interest every year together with the repayment of part of the borrowing.
The company however will get tax shield for both the interest paid as well as for
depreciation. The resultant cash flows may be evaluated as follows:
YEAR INTEREST DEP INT.+DEP TAX REPAYMENT NET PV
@.15 SHIELD CASH
ON @.16
INT+DEP
1 150000 150000 300000 150000 200000 200000 -172400
2 120000 127500 247500 123750 200000 196250 -145814
3 90000 108375 198375 99188 200000 190812 122310
4 60000 92120 152120 76060 200000 183940 -101535
5 30000 78300 108300 54150 200000 175850 -83705
5 SCRAP +100000
VALUE
47600
NET PRESENT VALUE OF OUTFLOWS: 578164

OPTION II: In this case the company has to pay a lease rental of rs. 3,30,000 on which tax
shield will be Rs. 165000. So the annual net outflow will be Rs. 165000 only for 5 years.
The PVAF for 16% for 5 years is 3.274. the pv of outflows may be ascertained as follows:
PV OF OUTFLOWS= 165000*3.274= 540210
SINCE OV OF OUTFLOWS IS LOWER IN LEASING OPTION, IT IS BETTER TO GO FOR THIS.