1. 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 to
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 a 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 instalment becoming
due at the end of the each year. Alternatively, the machine can be taken on year-end
lease rentals of Rs. 4,50,000 for 5 years. Advice the company on the option it should
choose. For your exercise, you may assume the following:
a. The machine will constitute a separate block for depreciation purposes. The
company follows written down value method of depreciation, the rate of
depreciation being 20 per cent.
b. Tax rate is 35 per cent and cost of capital is 20 per cent.
c. Lease rentals are to be paid at the end of the year.
d. Maintenance expenses estimated at Rs. 30,000 per year are to be borne by the
lessee.

Solution is as follows:

The company should first evaluate the Leasing Option:

a. Evaluating the Present value of cash outflow under leasing option:

years Cash outflow after PV (before PVIFA (n=5yrs, Present value of

tax tax) r=13%) cash outflow
4,50,000 – 35% of 13% (20 – 35% of
1–5 20% Rs. 10,28,723
4,50,000 = 2,92,500 20)= 3.515
b. Evaluating the present value of cash outflow under buying option:
First we find instalment amount:
PV
Instalment =
PVIFAr=20%, n = 5 yrs
15 ,00,000
Instalment = = 5,01 ,505
2.991
Second we should prepare amortization schedule:

Year end Loan Loan at the beginning Payments Loan outstanding at

instalment at the year Interest Principal the end of the year
1 5,01,505 15,00,000 3,00,000 2,01,505 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 -----
Thirdly we should calculate the depreciation for the asset under WDV method

Years Depreciation
1 3,00,000
2 2,40,000
3 1,92,000
4 1,53,600
5 1,22,880
Total depreciation 10,08,480
Capital Loss = (cost of the 3,91,520
asset – total depreciation
– Scrap value)
Lastly should determine the present value of cash outflow under buying option:

Year Instalment Tax advantage on Net cash PVIF Present

end Interest Depreciation out flow at value of cash
(0nly (only 35%) 13% outflow
35%)
1 2 3 4 5 = 2 - (3 + 4) 6 7 (5 * 6)
1 5,01,505 1,05,00 1,05,000 2,91,505 0.885 2,57,982
2 5,01,505 0 84,000 3,26,610 0.783 2,55,736
3 5,01,505 90,895 67,200 3,60,337 0.693 2,49,714
4 5,01,505 73,968 53,760 3,94,089 0.613 2,41,577
5 5,01,505 53,656 43,008 4,29,383 0.543 2,33,155
29,114
Total 12,38,164
Less: Present value of scrap (1,00,000 x 0.543) 54,300
Less: PV of tax savings on capita loss (3,91,520 x 0.35 x 0.543) 74,408
Net present value of buying option 11,09,456
The company is advised to go for leasing since its PV of cash outflow is less than the
buying option
 2. XYZ Builders Ltd need to acquire the use of a crane for their construction business, and
are considering buying or leasing a crane. The crane costs Rs. 10,00,000, and is subject
to the SLM of depreciation of Zero salvage value at the end of 5 years.
In contrast, the lease rent is Rs. 2,20,000 per year to be paid in advance
each year for 5 years. XYZ Builders Ltd can raise debt at 14 per cent payable in equal
annual instalment, each instalment due at the beginning of the year. The company is in
the 50 per cent tax bracket. Should it lease or buy the crane?

Solution is as follows:

The company should first evaluate the Leasing Option:

a. Evaluating the Present value of cash outflow under leasing option:

Years Cash outflow Cash outflow PVIFA (n=5yrs, Present value of

before tax after tax r=7%) cash outflow
0 Rs. 2,20,000 Rs. 2,20,000 1.000 Rs. 2,20,000
1–4 Rs. 2,20,000 Rs. 1,10,000 3.387 Rs. 3,72,570
5 --- (1,10,000) 0.713 (Rs. 78,430)
Present Value of cash outflow of lease financing 5,14,140
b. Evaluating the present value of cash outflow under buying option:
First we find instalment amount:
PV
Instalment =
PVIFA r=14%,n = 4 yrs + 1
10,00,000
Instalment = = 2,55,493
3.914
Second we should prepare amortization schedule:
Note: in advance payment of EMI, first year EMI includes only principal amount and
no interest payment. So, full EMI should be reduced from loan instalment.

Year Loan Loan at the beginning Payments Loan outstanding at

end instalment at the year Interest Principal the end of the year
1 2,55,493 10,00,000 --- 2,55,493 7,44,507
2 2,55,493 7,44,507 1,04,231 1,51,262 5,93,245
3 2,55,493 5,93,245 83,054 1,71,439 4,20,806
4 2,55,493 4,20,806 58,913 1,96,580 2,24,226
5 2,55,493 2,24,226 31,267 2,24,226 ---
Thirdly we should calculate the depreciation for the asset under SLM method:
 Cost of the asset − Scrap value
Depreciation =
Life of the asset
10, 00, 000
Depreciation = = Rs . 2, 00, 000
5
Lastly should determine the present value of cash outflow under buying option:

Year Instalment Tax advantage on Net cash out PVIF Present

end Interest Depreciation flow at value of cash
(50%) (only 50%) 13% outflow
1 2 3 4 5 = 2 - (3 + 4) 6 7 (5 * 6)
0 2,55,493 2,55,493 1.000 2,55,493
1 2,55,493 52,115 1,00,000 1,03,378 0.935 96,658
2 2,55,493 41,527 1,00,000 1,13,966 0.873 99,492
3 2,55,493 29,456 1,00,000 1,26,037 0.816 1,02,846
4 2,55,493 15,633 1,00,000 1,39,860 0.763 1,06,713
5 ---- 1,00,000 (1,00,000) 0.713 (-71,300)
Net present value of buying option 5,89,902
The company is advised to go for leasing since its PV of cash outflow is less than the
buying option
Points to be remembered when lease rent/EMI is paid in advance

 Leasing option
o When lease rent is paid in advance, the tax benefit for that year will be taken in
next year. Like that when lease rent is paid at the end of the period, the tax
advantage of the same will be taken in the next year.
o Lease rent is paid in the beginning of every year. 0 year, 1 st year, 2nd year, 3rd year
and 4th year.
o So, in fifth year there will be no lease rent but only tax advantage of the previous
year lease rent payment will be shown.
o Last year tax advantage on lease rent has to be subtracted from total value of
lease rentals paid
 Buying option
o Instalment equation will be as Present Value / (PVIFA + 1)
o First EMI will be of only principal. No interest will be included in 1st EMI.
o Interest payment will begin from 1st year in case of advance EMI. If the life of the
asset is 5years, then interest will be paid only for 4 years, when life is 10 years,
interest is paid for only 9 years and so on.
o Depreciation will be for full life of the asset. If the life of the asset is 5 years then
it will be taken for full years at the end of the year.
 o There will be no capital loss in the case of SLM of depreciation as full amount of
asset will be recovered by the end of its life.

3. An industrial unit desires to acquire a diesel generating set costing Rs. 20,00,000 which
has as an economic life of 10 years at the end of which the asset is not expected to have
any residual value. The unit is considering the alternative choices of (a) taking the
machinery on lease, or (b) purchasing the asset outright by raising a loan.
Lease payments Rs. 2,95,902 are to be made in advance and the lessor
requires the asset to be completely amortized over its useful period.
The cost of debt is worked out at 16 per cent per annum. The
lender requires the loan to be repaid in 10 equal installments becoming due at the
beginning of the first year. Average rate of income tax is 50 per cent. It is expected that
the operating costs would remain the same under either method. The firm follows SLM
of depreciation and the same is accepted for tax purposes. As a financial consultant,
indicate what your advice will be.

Solution is as follows:
a. To determine the Present value of cash outflow under leasing option:
Evaluating the Present value of cash outflow under leasing option:

Years Cash outflow Cash outflow PVIFA (n=5yrs, Present value of

before tax after tax r=7%) cash outflow
0 Rs. 2,95,902 Rs. 2,95,902 1.000 Rs. 2,95,902
1–9 Rs. 2,95,902 Rs. 1,47,951 6.247 Rs. 9,24,250
10 --- (1,47,951) 0.463 (Rs. 68,501)
Present Value of cash outflow of lease financing 11,51,651
b. Evaluating the present value of cash outflow under buying option:
First we find instalment amount:
PV
Instalment =
PVIFA r=16%, n = 9 yrs + 1
20,00 ,000
Instalment = = Rs .3 ,56 ,697
5.607
Second we should prepare amortization schedule:
Note: in advance payment of EMI, first year EMI includes only principal amount and
no interest payment. So, full EMI should be reduced from loan instalment.
 Year Loan Loan at the Payments Loan due at
end instalment beginning Interest Principal the end of
at the year the year
1 2 3 4 (3*16%) 5=(2 – 4) 6
0 3,56,697 20,00,000 ---- 3,56,697 16,43,303
1 3,56,697 16,43,303 2,62,928 93,769 15,49,534
2 3,56,697 15,49,534 2,47,925 1,08,772 14,40,762
3 3,56,697 14,40,762 2,30,522 1,26,175 13,14,587
4 3,56,697 13,14,587 2,10,334 1,46,363 11,68,224
5 3,56,697 11,68,224 1,86,916 1,69,781 9,98,443
6 3,56,697 9,98,443 1,59,751 1,96,946 8,01,497
7 3,56,697 8,01,497 1,28,240 2,28,457 5,73,040
8 3,56,697 5,73,040 91,686 2,65,011 3,08,029
9 3,56,697 3,08,029 48,668 3,08,029 ---
Thirdly we should calculate the depreciation for the asset under SLM method:
Cost of the asset − Scrap value
Depreciation =
Life of the asset
20, 00, 000
Depreciation = = Rs . 2, 00, 000
10
Lastly should determine the present value of cash outflow under buying option:

Year Instalment Tax advantage on Net cash out PVIF Present

end Interest Depreciation flow at 8% value of cash
(50%) (only 50%) outflow
1 2 3 4 5 = 2 - (3 + 4) 6 7 (5 * 6)
0 3,56,697 3,56,697 1.000 3,56,697
1 3,56,697 1,31,46 1,00,000 1,25,233 0.926 1,15,966
2 3,56,697 4 1,00,000 1,32,735 0.857 1,13,754
3 3,56,697 1,23,96 1,00,000 1,41,436 0.794 1,12,300
4 3,56,697 2 1,00,000 1,51,530 0.735 1,11,375
5 3,56,697 1,15,26 1,00,000 1,63,239 0.681 1,11,166
6 3,56,697 1 1,00,000 1,76,822 0.630 1,11,398
7 3,56,697 1,05,16 1,00,000 1,92,557 0.583 1,12,272
8 3,56,697 7 1,00,000 2,10,854 0.540 1,13,861
9 3,56,697 93,458 1,00,000 2,32,363 0.500 1,16,181
10 3,56,697 79,875 1,00,000 (1,00,000) 0.463 (46,300)
 64,120
45,843
24,334

Net present value of buying option 13,28,670

The company is advised to go for leasing since its PV of cash outflow is less than the
buying option

4. Alfa Ltd., is thinking of installing a computer. Decide whether the computer is to be

purchased outright through 14 per cent borrowings or to be acquired on lease rental
basis. The company is in the 50 per cent tax bracket. The other data available are:
Purchase of computer:
 Purchase price Rs. 20,00,000
 Annual maintenance (to be paid in advance), Rs. 50,000 per year
 Expected economic useful life 6 years
 Depreciation (for tax purposes), SLM
 Salvage value: Rs. 2,00,000

Leasing of computer:

 Lease charges (to be paid in advance): Rs. 4,50,000

 Maintenance expenses to be borne by lessor
Payment of loan: 6 year-end installments of Rs. 5,14,271

Solution is as follows:

a. To determine the Present value of cash outflow under leasing option:

Evaluating the Present value of cash outflow under leasing option:

Years Cash outflow Cash outflow PVIFA (n=5yrs, Present value of

before tax after tax r=7%) cash outflow
0 Rs. 4,00,000* --- 1.000 Rs. 4,00,000
1–5 Rs. 4,00,000 Rs. 2,00,000 4.100 Rs. 8,20,000
6 --- Rs.2,00,000 0.666 (1,33,200)
Present Value of cash outflow of lease financing 10,86,800
Note: Rs. 4,00,000* = 4,50,000 – 50,000 (maintenance expenses) to be borne by the
lessee.
b. Evaluating the present value of cash outflow under buying option:
Since, the instalment amount is given we should prepare the loan amortization
schedule.

Year Loan Loan at the Payments Loan due at

end instalment beginning Interest Principal the end of
at the year the year
1 2 3 4 (3*14%) 5=(2 – 4) 6 (3 – 5)
1 5,14,271 20,00,000 2,80,000 2,34,271 17,65,729
2 5,14,271 17,65,729 2,47,202 2,67,069 14,98,660
3 5,14,271 14,98,660 2,09,812 3,04,459 11,94,201
4 5,14,271 11,94,201 1,67,188 3,47,083 8,47,118
5 5,14,271 8,47,118 1,18,596 3,95,675 4,51,443
6 5,14,271 4,51,443 62,828 4,51,443 ---
Thirdly we should calculate the depreciation for the asset under SLM method:
Cost of the asset − Scrap value
Depreciation =
Life of the asset
20 ,00,000 − 2,00,000
Depreciation = = Rs. 3,00,000
6
Lastly should determine the present value of cash outflow under buying option:

Year Instalment Tax advantage on Net cash out PVIF Present

end Interest Depreciation flow at 7% value of cash
(50%) (only 50%) outflow
1 2 3 4 5 = 2 - (3 + 4) 6 7 (5 * 6)
1 5,14,271 1,40,00 1,50,000 2,24,271 0.935 2,09,693
2 5,14,271 0 1,50,000 2,40,670 0.873 2,10,105
3 5,14,271 1,23,60 1,50,000 2,59,365 0.816 2,11,642
4 5,14,271 1 1,50,000 2,80,677 0.763 2,14,157
5 5,14,271 1,04,90 1,50,000 3,04,975 0.713 2,17,446
6 5,14,271 6 1,50,000 3,32,857 0.666 2,21,683
83,594
59,298
31,414
Present value of buying option 12,84,726
Less: present value of scrap value (2,00,000 * 0.666) (1,33,200)
Net present value of cash outflow under buying option 11,51,526
The company is advised to go for leasing since its PV of cash outflow is less than the
buying option
5. ABC Machine Tool Company Limited is considering the acquisitions of a large equipment
to west up its factory in a backward region for Rs. 12,00,000. The equipment to have an
economic life of 8 years.
The equipment can be financed either with an 8 – year term loan at 14
per cent interest, repayable in equal installments of Rs. 2,58,676 per year, or by an
equivalent amount of lease rent per year. In both cases, payments are due at the end of
the year. The equipment is subject to the SLM of depreciation for tax
purposes. Assuming no salvage value after the 8 – year useful life and 50 per cent tax
rate, which of the financing alternatives should it select?

Solution is as follows:

a. To determine the Present value of cash outflow under leasing option:

Evaluating the Present value of cash outflow under leasing option:

Years Cash outflow Cash outflow PVIFA (n=8yrs, Present value of

before tax after tax (50%) r=7%) cash outflow
1–8 2,58,676 1,29,338 5.971 7,72,277
Present Value of cash outflow of lease financing 7,72,277
Note: Rs. 4,00,000* = 4,50,000 – 50,000 (maintenance expenses) to be borne by the
lessee.
b. Evaluating the present value of cash outflow under buying option:
Since, the instalment amount is given we should prepare the loan amortization
schedule.

Year Loan Loan at the Payments Loan due at

 end instalment beginning Interest Principal the end of
at the year the year
1 2 3 4 (3*14%) 5=(2 – 4) 6 (3 – 5)
1 2,58,676 12,00,000 1,68,000 90,676 11,09,324
2 2,58,676 11,09,324 1,55,305 1,03,371 10,05,953
3 2,58,676 10,05,953 1,40,833 1,17,843 8,88,110
4 2,58,676 8,88,110 1,24,335 1,34,341 7,53,769
5 2,58,676 7,53,769 1,05,528 1,53,148 6,00,621
6 2,58,676 6,00,621 84,087 1,74,589 4,26,032
7 2,58,676 4,26,032 59,644 1,99,032 2,27,000
8 2,58,676 2,27,000 31,676 2,27,000 ---

Thirdly we should calculate the depreciation for the asset under SLM method:
Cost of the asset − Scrap value
Depreciation =
Life of the asset
12, 00, 000
Depreciation = = Rs. 1, 50,000
8
Lastly should determine the present value of cash outflow under buying option:

Year Instalment Tax advantage on Net cash out PVIF Present

end Interest Depreciation flow at 7% value of cash
(50%) (only 50%) outflow
1 2 3 4 5 = 2 - (3 + 4) 6 7 (5 * 6)
1 2,58,676 84,000 75,000 99,676 0.935 93,197
2 2,58,676 77,652 75,000 1,06,024 0.873 92,559
3 2,58,676 70,416 75,000 1,13,260 0.816 92,420
4 2,58,676 62,167 75,000 1,21,509 0.763 92,711
5 2,58,676 52,764 75,000 1,30,912 0.713 93,340
6 2,58,676 42,043 75,000 1,41,633 0.666 94,328
7 2,58,676 29,822 75,000 1,53,854 0.623 95,851
8 2,58,676 15,838 75,000 1,67,838 0.582 97,682
Present value of buying option 7,52,088
The company is advised to go for buying opinion since its PV of cash outflow is less
than the leasing option

6. The controller of General Electronics Corporation of India Limited has been analyzing
the firm’s policy regarding computers, which are now being leased on a yearly basis on
rental amounting to Rs. 1,00,000 per year. The computers can be bought for Rs.
5,00,000. The purchase should be financed by 16 per cent loan repayable in 4 equal
annual installments.
On account of rapid technological progress in the computer industry, it is
suggested that a 4 – year economic life should be used, instead of the 10 year physical
 life. It is estimated that the computers would be sold for Rs. 2,00,000 at the end of 4
years.
The company uses the SLM of depreciation. Corporate tax rate is 50 per
cent.
a. Comment on whether the equipment should be bought or leased?
b. Analyse the financial viability from the point of view of the lessor, assuming 14
per cent cost of capital.
c. Determine the minimum lease rent at which the lessor would break even.

Solution is as follows:

a. To determine the Present value of cash outflow under leasing option:

Evaluating the Present value of cash outflow under leasing option:

Years Cash outflow Cash outflow PVIFA (n=4yrs, Present value of

before tax after tax (50%) r=8%) cash outflow
1–4 1,00,000 50,000 3.312 1,65,600
Present Value of cash outflow of lease financing 1,65,600
b. Evaluating the present value of cash outflow under buying option:
First we should determine the Installment amount:
PresentValue
EMI =
PVIFA r=16%, n=4 yrs
5,00,000
EMI = = 1,78,699
2.798
Secondly we should prepare the loan amortization schedule.

Year Loan Loan at the Payments Loan due at

end instalment beginning Interest Principal the end of
at the year the year
1 2 3 4 (3*14%) 5=(2 – 4) 6 (3 – 5)
1 1,78,699 5,00,000 80,000 98,699 4,01,301
2 1,78,699 4,01,301 64,208 1,14,491 2,86,810
3 1,78,699 2,86,810 45,890 1,32,809 1,54,001
4 1,78,699 1,54,001 24,698 1,54,001 ---

Thirdly we should calculate the depreciation for the asset under SLM method:
Cost of the asset − Scrap value
Depreciation =
Life of the asset
5,00,000 − 2,00,000
Depreciation = = Rs. 75,000
4
Lastly should determine the present value of cash outflow under buying option:
 Year Instalment Tax advantage on Net cash out PVIF Present
end Interest Depreciation flow at 7% value of cash
(50%) (only 50%) outflow
1 2 3 4 5 = 2 - (3 + 4) 6 7 (5 * 6)
1 1,78,699 40,000 37,500 1,01,199 0.926 93,710
2 1,78,699 32,104 37,500 1,09,095 0.857 93,494
3 1,78,699 22,945 37,500 1,18,254 0.794 93,894
4 1,78,699 12,349 37,500 1,28,850 0.735 94,705
Present value of buying option 3,75,803
Less: Present value of scrap value (2,00,000 x 0.735) (1,47,000)
Net Present value of buying option 2,28,803
The company is advised to go for leasing opinion since its PV of cash outflow is less
than the buying option

c. Viability form the lessor’s point of view: from the lessor point of view it is
investment (cash out flow) that he is going to make in the asset. To know the
feasibility of any investment we should determine the NPV.
NPV = Present value of cash outflows - Initial Investment
Cash outflow = PATBD

So, first we should determine his PATBD. Since the depreciation is

under the SLM, we should adopt the annuity method to know the cash inflows:

Particulars amount
Lease rent received 1,00,000
Less: depreciation 75,000
EBT 25,000
Less: tax 12,500
PAT 12,500
Add: depreciation 75,000
PATBD 87,500
Present value of cash inflows under annuity method is as follows:

PV of cash inflows= [cash inflow x PVIFAr=14%, n=4 yrs] + [Scrap value x PVIFn=4 yrs, r=14%]

PV of cash inflow = [87,500 x 2.914] + [2,00,000 x 0.592] = 3,73,375

NPV = Present value of cash inflow - Initial Investment

NPV = 3,73,375 – 5,00,000 = (-) 1,26,625

The proposal is not financially viable to the lessor since, its NPV is of negative value.
d. Lease rent at which the lessor would break even: here, break even will be
measure from cash inflows point of view. To know the net cash inflow from the
lessor point, we should determine how much he has to recover from his
investment after subtracting his other income such as salvage value.

Particulars Amount
Cost of computer 5,00,000
Less: PV of salvage price of computers 1,18,400
Net cost to be recovered 3,81,600
Divide by PV annuity factor(n=14 yrs, r=4%) (2.914)
PATBD 1,30,954
Less: Depreciation 75,000
PAT 55,954
Add: Taxes 55,954
EBT 1,11,908
Add: Depreciation 75,000
Lease rental (desired) 1,86,908