CA –FINAL STRATEGIC FINANCIAL MANAGEMENT

LEASING DECISION
Introduction:
❖ Leasing is a financial transaction under which the owner of the asset transfers the
right to use the asset for a defined period of time for a periodic consideration.
Features of leasing transaction:
Features Lessor Lessee
Asset Owner User
Lease rental Taxable income Tax deductible expense
Depreciation Yes No

Leasing
Decision

Lessor Lessee

Capital
Financing
Budgeting
decision
Decision

Evaluation from Lessor’s angle:

❖ For the lessor this is an investment decision. All principles of capital budgeting will
apply
❖ Lease if NPV is positive
❖ Lease if IRR > cost of capital

Evaluation from Lessee’s angle:

❖ The lessee has the following two choices
o Take the asset on lease
o Buy the machine
❖ In the case of lessee the decision to have the asset is already made. The only remaining
decision is how to finance the asset namely
o Buy the asset by taking a loan
o Take the asset on lease
❖ The lessee should choose the alternative which has lower PV of outflow

Steps:
❖ Step 1: Compute PV of Borrow & Buy Option
Purchase Price XXX

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Less: PV of tax saved on depreciation (XXX)
Less: PV of net salvage value (XXX)
PV of borrow and buy option XXX
Note:
❖ The interest rate is irrelevant because the borrowing rate and the discount rate are
same
❖ The appropriate discount rate to be used is after tax cost of debt. However if the
problem specifies different discount rate then in-between outflows are to be calculated
by considering the interest and instalment payment.

❖ Step 2: Compute PV of after tax lease rental

❖ Step 3: Compare step 1 and step 2 and select the option with lower present value

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Topic 11: Leasing Decision – Lessor Evaluation

1. Fixing lease rental (May 2012 RTP)

Armada Leasing Company is considering a proposal to lease out a school bus. The bus can be
purchased for Rs. 4, 00,000 and, in turn, be leased out at Rs. 1, 50,000 per year for 4 years with
payments occurring at the end of each year:
(i) Estimate the internal rate of return for the company assuming tax ignored
(ii) What should be the yearly lease payment charged by the company in order to earn 20%
annual compound rate of return before expenses and taxes in the following scenarios:
a) Equated lease rentals
b) Stepped up lease rental (annual increase of 10 percent)
c) Ballooned (annual payment of Rs.1, 00,000 for year 1 to 2 & rent of year 4 will have an
increase of 10 percent)
d) Deferred (2 year deferment period)
(iii) Calculate the annual lease rent to be charged so as to amount to 20% after tax annual
compound rate of return, based on the following assumptions:
(a) Tax rate 40%,
(b) Straight line depreciation
(c) annual expenses of Rs. 50,000 and
(d) resale value of Rs. 1, 00,000 after the term.

2. Fixing Lease rental

Classic Finance, a Leasing Company, has been approached by a prospective customer
intending to acquire a machine whose cash down price is Rs. 6 crores. The customer, in order
to leverage his tax position, has requested a quote for a three year lease with rentals payable
at the end of each year but in a diminishing manner such that they are in the ratio of 3: 2: 1.
Depreciation can be assumed to be on WDV basis at 25% and Classic Finance's marginal tax
rate is 35%. The target rate of return for Classic Finance on the transaction is 10%. You are
required to calculate the lease rents to be quoted for the lease for three years.

3. Fixing Lease rental

ABC Limited is in the process of making out a proposal to lease certain equipment to a user-
manufacturer. The cost of the equipment is expected to be Rs.10 lakhs and the primary period
of lease to be 10 years. ABC Limited is able to give you the following additional information:
❖ The machine can be depreciated fully over the 10 years on SLM
❖ The current effective tax rate is 40% and they expect it to go down to 30% from the
beginning of the 6th year of the lease
❖ It is the normal objective of ABC to make a 10% post-tax return in its lease pricing
❖ Lease management fee of 1% of the value of the asset is usually collected from the
lessees upon signing of the contract of lease, to cover the overhead costs related to
processing of the proposal
❖ Annual lease rents are collected at the beginning of every year
You are required to determine the equated annual rent to be charted for the proposal.

4. Fixing lease rentals

ABC Limited has been approached by a foreign embassy to build for them a block of 6 flats to
be used as guest houses. As per the terms of contract the foreign embassy would provide ABC
Limited the plans and the land costing of Rs.25 lakhs. ABC Limited would build the flats at
their own cost and lease them out to foreign embassy for rental chargeable on annual basis
and at the end of 15 years the buildings shall be transferred to the embassy for a nominal value
of Rs.8 lacs. ABC Limited estimate the cost of construction as follows:

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❖ Area per flat is 1000 square feet
❖ Construction cost is Rs.400 per square feet
❖ Registration and other charges is 2.5 percent of cost of construction
❖ ABC Limited will also incur Rs.4 lacs each in year 14 and 15 towards repairs
❖ ABC Limited propose to charges the lease rentals as follows
o Year 1 to 5 – Normal lease rental
o Year 6 to 10 – 120% of normal rentals
o Year 11 to 15 – 150% of normal rentals

ABC Limited present tax rate averages at 50%. The full cost of construction and registration
will be written off in 15 years and will be allowed for tax purpose. You are required to
calculate the normal lease rental per flat with following assumptions:
❖ Minimum desired return of 10%
❖ Rental and repairs will arise on last day of each year
❖ Construction and registration and other cost will be incurred today

5. Fixing of break-even rental

A Company is planning to acquire a machine costing Rs. 5, 00,000. Effective life of the machine
is 5 years. The Company is considering two options. One is to purchase the machine by lease
and the other is to borrow Rs.5,00,000 from its bankers at 10% interest p.a. The Principal
amount of loan will be paid in 5 equal instalments to be paid annually. The machine will be
sold at Rs. 50,000 at the end of 5th year. Following further information is given:
❖ Principal, interest, lease rentals are payable on the last day of each year.
❖ The machine will be fully depreciated over its effective life.
❖ Tax rate is 30% and after tax Cost of Capital is 8%.

Compute
❖ Lease rentals payable which will make the firm indifferent to the loan option.
❖ Interest rate payable which will make the firm indifferent to the loan option if the
Lease rentals are Rs.1, 20,000
❖ Residual value which will make the firm indifferent to the loan option with lease
rentals of Rs.1, 20,000
❖ Initial cost payable which will make the firm indifferent to the loan option with lease
rentals of Rs.1, 20,000

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Topic 12: Leasing Decision – Lessee Evaluation

1. Choice of lease
P Ltd. has decided to acquire a machine costing Rs. 50 lakhs through leasing. Quotations from
2 leasing companies have been obtained which are summarized below:
Quote A Quote B
Lease term 3 years 4 years
Initial lease rent (Rs. Lakhs) 5.00 1.00
Annual lease rent (payable in arrears) [Rs. Lakhs] 21.06 19.66
P Ltd. evaluates investment proposals at 10% cost of capital and its effective tax rate is 30%.
Terminal payment in both cases is negligible and may be ignored. Make calculations and show
which quote is beneficial to P Ltd. Present value factors at 10% rate for years 1-4 are
respectively 0.91, 0.83, 0.75 and 0.68. Calculations may be rounded off to 2 decimals in lakhs.

2. Lease Versus Buy – Discounting rate same as after tax cost of debt
M/s Gama & Co. is planning of installing a power saving machine and are considering
buying or leasing alternative. The machine is subject to straight-line method of
depreciation. Gama & Co. can raise debt at 14% payable in five equal annual instalments
of Rs. 1,78,858 each, at the beginning of the year. In case of leasing, the company would be
required to pay an annual end of year rent of 25% of the cost of machine for 5 years. The
Company is in 40% tax bracket. The salvage value is estimated at Rs. 24,998 at the end of
5 years.
❖ Evaluate the two alternatives and advise the company by considering after tax
cost of debt concept under both alternatives.
❖ Calculate the Annual Percentage Rate (APR) implied by the bank’s offer with interest
payable every six months. Also calculate the amount of installment payable at the
beginning of each six-month period if the offered loan to be repaid in equal
installments.

3. Lease versus buy

Bright Limited is considering acquiring an additional sophisticated computer to augment its
time-share computer services to its clients. It has two options
(i) To purchase the computer at cost of Rs. 44, 00,000 or,
(ii) To take the computer on lease for 3 years from a leasing company at an annual lease rental
of Rs. 10 lacs plus 10% of the gross time-share service revenue. The agreement also requires
an additional payment of Rs. 12 lacs at the end of the third year. Lease rentals are payable at
the year end and the computer reverts back to lessor after period of contract.

The company estimates that the computer will be worth Rs. 20 lacs at the end of the third year.
The Gross revenue to be earned are as follows:
Year Rs. In Lacs
1 45
2 50
3 55
Annual operating cost (excluding depreciation/lease rental) are estimated at Rs. 18 lacs with
an additional cost Rs. 2 lacs for strap up and trading at the beginning of the first year. These
costs are to be borne by the lessee in case of lease arrangement also. The Company proposes
to borrow @ 16% interest to finance the purchase of the computer and the repayments are to
be made in equated annual instalments. For the purpose of this computation assume that the
company uses the straight line method of depreciation on assets and pays 50% tax on this
income. You are required to evaluate whether to lease or buy the asset
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4. Lease versus Buy – Discounting rate different from cost of debt
XYZ Ltd. requires an equipment costing Rs. 10,00,000; the same will be utilized over a
period of 5 years. It has two financing options in this regard :
❖ Arrangement of a loan of Rs. 10,00,000 at an interest rate of 13 percent per
annum; the loan being repayable in 3 equal year end installments; the equipment
can be sold at the end of third year for Rs.1,00,000.
❖ Leasing the equipment for a period of three years at an yearly rental of Rs.5,50,000
payable at the year end.
The rate of depreciation is 40 percent on Written Down Value (WDV) basis, income tax
rate is 35 percent (paid one year in arrears) and discount rate is 12 percent. Advise which of
the financing options should XYZ Ltd. exercise and why?

5. Sale and leaseback

X Ltd. had only one water pollution control machine in this type of block of asset with no book
value under the provisions of the Income Tax Act, 1961 as it was subject to rate of depreciation
of 100% in the very first year of installation.
Due to funds crunch, X Ltd. decided to sell the machine which can be sold in the market to
anyone for Rs.5, 00,000 easily. Understanding this from a reliable source, Y Ltd. came forward
to buy the machine for Rs.5, 00,000 and lease it to X Ltd. for lease rental of Rs.90, 000 p.a. for 5
years. X Ltd. decided to invest the net sale proceed in a risk free deposit, fetching yearly
interest of 8.75% to generate some cash flow. It also decided to retake the entire issue afresh
after the said period of 5 years.
Another company, Z Ltd. also approached X Ltd. proposing to sell a similar machine for
Rs.4,00,000 to the latter and undertook to buy it back at the end of 5 years for Rs.1,00,000
provided the maintenance were entrusted to Z Ltd. for yearly charge of Rs.15,000. X Ltd.
would utilize the net sale proceeds of the old machine to fund this machine also should it
accept this offer. The marginal rate of tax of X Ltd. is 34% and its weighted average cost of
capital is 12%. Which Alternative would you recommend?

6. Lease versus Buy

R Limited requires a machine for 5 years. There are two alternatives either to take it on lease
or buy. The company is reluctant to invest initial amount for the project and approach their
bankers. Bankers are ready to finance 100% of its initial required amount at 15% rate of interest
for any of the alternatives.
Under lease option, upfront security deposit of Rs.5,00,000 is payable to lessor which is equal
to cost of machine. Out of which,40% shall be adjusted equally against annual lease rent. At
the end of life of the machine, expected scrap value will be at book value after providing
deprecation @ 20% on written down value basis.
Under buying option, loan repayment is in equal annual installments of principal amount,
which is equal to annual lease rent charges. However in case of bank finance for lease option,
repayment of principal amount equals to lease rent adjusted every year, and the balance at
the end of 5th year.
Assume income tax rate is 30%, interest is payable at the end of every year and discount rate
is 15% p.a. Which option would you suggest on the basis of net present value?
7. Leasing – Monthly rentals
A company has received three proposals from leasing companies for the acquisition of an
asset on lease costing Rs.1,50,000.

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Option 1: The terms of offer envisaged payment of rentals for 96 months. During the first 72
months the lease rental were to be paid @Rs.30 p.m. per Rs.1,000 and during the remaining
months @ Rs.5 per month. On the expiry of lease period, the lessor has offered to sell the assets
at 50% of the original cost.

Option 2: Another offer envisaged lease agreement for a period of 72 months during which
lease rentals were to be paid as follows:
Year 1 2 3 4 5 6
Lease rental per Rs.1,000 35 30 26 24 22 20
At the end of lease period the asset is proposed to be abandoned.

Option 3: Under this offer a lease agreement is proposed to be signed for a period of 60 months
wherein an initial lease deposit to the extent of 15% will be made at the time of signing of
agreement. Lease rentals of Rs.35 per Rs.1,000 per month will have to be paid for period of 60
months and on the expiry of the leasing arrangement, the assets shall be sold against the initial
deposit and the asset is expected to last for a further period of three years. You are required
to evaluate the proposals keeping in view the following parameters.
❖ SLM method of depreciation
❖ Discounting rate @ 15%
❖ Tax rate is 40%
The monthly and yearly discounting factors @ 15% discount rate are as follows:
Year Monthly discounting factor Yearly discounting factor
1 0.923 0.869
2 0.795 0.756
3 0.685 0.658
4 0.590 0.572
5 0.509 0.497
6 0.438 0.432
7 0.377 0.376
8 0.325 0.327
9 0.280 0.284
10 0.241 0.247
11 0.208 0.215
12 0.179 0.187
8. Sensitivity analysis in lease versus loan
Khalid Tour Operator Ltd. is considering buying a new car for its fleet for local touring
purpose. Purchase Manager has identified Renault Duster model car for acquisition.
Company can acquire it either by borrowing the fund from bank at 12% p.a. or go for leasing
option involving yearly payment (in the end) of Rs. 2,70,000 for 5 years. The new car shall
cost Rs. 10,00,000 and would be depreciable at 25% as per WDVmethod for its owner.
The residual value of car is expected to be Rs. 67,000 at the end of 5 years. The corporate tax
rate is 33%. You are required to:
❖ Calculate which of the two options borrowings or leasing shall be financially more
advantageous for the Company.
❖ Measure the sensitivity of Leasing/ Borrowing Decision in relation to each of the
following parameters:
o Rate of Borrowing
o Residual Value
o Initial Outlay
Among above which factor is more sensitive.

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