VASUDHA JAIN CLASSES – Strategic Financial Management (Group 3)

Module 3 3
LEASING DECISIONS
Covering ALL CMA MODULE QUESTIONS

Illustration 1 (Classroom question) New 2022 CMA MODULE SOLVED CASE STUDY
PQR Ltd. is considering to acquire an additional computer to supplement its time-share computer
services to its clients. It has two options:
(i) To purchase the computer for ₹22 lakhs.
(ii) To lease the computer for three years from a leasing company for ₹5 lakhs as annual lease
rent plus 10% of gross time-share service revenue. The agreement also requires an additional
payment of ₹6 lakhs at the end of the third year. Lease rents are payable at the year-end,
and the computer reverts to the lessor after the contract period.
The company estimates that the computer under review will be worth ₹10 lakhs at the end of third
year. Forecast Revenues are:
Year 1 2 3
Amount (₹ in lakhs) 22.5 25 27.5
Annual operating costs excluding depreciation/lease rent of computer are estimated at ₹9 lakhs with
an additional ₹ 1 lakh for start-up and training costs at the beginning of the first year. These costs
are to be borne by the lessee. Your company will borrow at 16% interest to finance the acquisition of
the computer. Repayments are to be made according to the following schedule:
Year end 1 2 3
Principal (₹ in '000) 500 850 850
Interest (₹ in '000) 352 272 136
The company uses straight line method (SLM) to depreciate its assets and pays 50% tax on its income.
The management approaches you to advice. Which alternative would be recommended and why?
Note: The PV factor at 8% and 16% rates of discount are:
Year 1 2 3
8% 0.926 0.857 0.794
16% 0.862 0.743 0.641
Solution:
Working Notes:
(a) Depreciation: ₹ (22,00,000 - 10,00,000)/3 = ₹ 4,00,000 p.a.
(b) Effective rate of interest after tax shield: 0.16 x (1 - 0.50) = 0.08 or 8%.
(c) Operating and training costs are common in both alternatives hence not considered while
calculating NPV of cash flows.
Calculation of NPV
1. Alternative I: Purchase of Computer
Particulars Year 1 Year 2 Year 3

Instalment Payment
Principal 5,00,000 8,50,000 8,50,000
Interest 3,52,000 2,72,000 1,36,000
Total (A) 8,52,000 11,22,000 9,86,000
Tax shield @ 50%;

60
 VASUDHA JAIN CLASSES – Strategic Financial Management (Group 3)

Interest payment 1,76,000 1,36,000 68,000

Depreciation 2,00,000 2,00,000 2,00,000
Total (B) 3,76,000 3,36,000 2,68,000

Net Cash outflows (A - B) 4,76,000 7,86,000 7,18,000

PV factor at 8% 0.926 0.857 0.794
PV of Cash outflows 4,40,776 6,73,602 5,70,092
Total PV of Cash outflows: 16,84,470
Less: PV of salvage value (₹ 10 lakhs x 0.794) 7,94,000
Net PV of cash outflows 8,90,470

2. Alternative II: Lease of the Computer

Particulars Year 1 Year 2 Year 3
Lease rent 5,00,000 5,00,000 5,00,000
10% of gross revenue 2,25,000 2,50,000 2,75,000
Lump sum payment - - 6,00,000
Total Payment 7,25,000 7,50,000 13,75,000
Less: Tax shield @ 50% 3,62,500 3,75,000 6,87,500
Net Cash outflows 3,62,500 3,75,000 6,87,500
PV of Cash outflows @ 8% 3,35,675 3,21,375 5,45,875
Total PV of cash outflows 12,02,925
Recommendation:
Since the Present Value (PV) of net cash outflow of Alternative I is lower, the company should purchase
the computer.

Illustration 2 (Classroom question) New 2022 CMA MODULE QUES 9

Fair finance, a leasing company, has been approached by a prospective customer intending to acquire a
machine whose Cash Down price is ₹ 3 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
straight line basis and Fair Finance's marginal tax rate is 35%. The target rate of return for Fair
Finance on the transaction is 12%.
Calculate the lease rents to be quoted for the lease for three years.

Solution:
Capital sum to be placed under Lease
Particulars ₹ in lakhs
Cash Down price of machine 300.00
Less: PV of depreciation tax shield [100 x 0.35 x PVIFA (12%, 3 years) = 35 x 2.4018] 84.06
215.94

If the normal annual lease rent per annum is x, then cash flow will be:
Year Post-tax cash flow P.V. of post-tax cash flow
1 3x x (1 - .35) = 1.95x 1.95 x (1/1.12) = 1.7411x
2 2x x (1 - .35) = 1.3x 1.30 x [(1/(1.12)2] = 1.0364x

61
 VASUDHA JAIN CLASSES – Strategic Financial Management (Group 3)

3 x x (1 - .35) = 0.65x 0.65 x [1/(1.12)3] = 0.4626x

= 3.2401x
Therefore 3.2401 x = 215.94
or, x = ₹ 66.6409 lakhs
Year-wise rentals are as follows: (₹ in lakhs)
Year 1 3 x 66.6409 lakhs = 199.9227
2 2 x 66.6409 lakhs = 133.2818
3 1 x 66.6409 lakhs = 66.6409

Illustration 3 (Classroom question) New 2022 CMA MODULE QUES 10

ABC Company Ltd. is faced with two options as under in respect of acquisition of an asset valued ₹
1,00,000/-
Either
(a) To acquire the asset directly by taking a Bank Loan of ₹ 1,00,000/- repayable in 5 year-end
instalments at an interest of 15%. OR
(b) To lease in the asset at yearly rentals of ₹ 320 per ₹ 1,000 of the asset value for 5 years
payable at year end.
The following additional information are available.
(a) The rate of depreciation of the asset is 15% W.D.V
(b) The company has an effective tax rate of 50%.
(c) The company employs a discounting rate of 16%.
You are to indicate in your report which option is more preferable to the Company.
Restrict calculation over a period of ten years
The present value of one Rupee due at the end of each year is
End of year 1 2 3 4 5 6 7 8 9 10
Present Value 0.86207 0.74316 0.64066 0.55229 0.47611 0.41044 0.35313 0.30503 0.26295 0.22668

Solution:
ABC Company Ltd
Appraisal of Buying Decision: PV of Cash Out Flows (fig in ₹)
Tax Net PV
Principal Tax savings Present
Year Interest Outflow savings on cash out factor
repayment on dep. value
int. flow @ 16%
1 20,000 15,000 35,000 7,500 7,500 20,000 0.86207 17,241.4
2 20,000 12,000 32,000 6,375 6,000 19,625 0.74316 14,584.5
3 20,000 9,000 29,000 5,420 4,500 19,080 0.64066 12,223.8
4 20,000 6,000 26,000 4,606 3,000 18,394 0.55229 10,158.8
5 20,000 3,000 23,000 3,915 1,500 17,585 0.47611 8,372.4
6 - - - 3,328 - (3,328) 0.41044 (1,366)
7 - - - 2,829 - (2,829) 0.35313 (999.0)
8 - - - 2,405 - (2,405) 0.30503 (733.6)
9 - - - 2,044 - (2,044) 0.26295 (537.5)
10 - - - 1,737 - (1,737) 0.22668 (393.7)
58,551.1
Net present value of outflows ₹ 58,551.1.
(b) Appraisal of Leasing Decision:
Present Value of Cash outflows under Lease Alternative

62
 VASUDHA JAIN CLASSES – Strategic Financial Management (Group 3)

Lease rent per year is 320/1,000 x 1,00,000 = ₹ 32,000

Lease rent Tax savings Net out flow Present value
Year PVCF @ 16%
(₹) (₹) (₹) (₹)
1-5 32,000 16,000 16,000 3.27429 52,390
PVCF = Present Value of Cash flow
From "a" and "b", it is advised to lease, Since the net cash outflow is lower under Lease alternative.
However, it is not wise to compare the two projects with different life periods. So, consider equivalent
annual cash outflows, which is calculated as follows,
Leasing: ₹ 52,390/3.27429 = ₹ 16,000
Buying: ₹ 58,552/4.83252 = ₹ 12,115.
So, it is advised to buy the asset.

Illustration 4 (Classroom question) New 2022 CMA MODULE QUES 11

Elite Builders has been approached by a foreign embassy to build for it a block of six flats to be used
as guest houses. As per the terms of the contract, the foreign embassy would provide Elite Builders
the plans and the land costing ₹ 25 lakhs. Elite Builders would build the flats at their own cost and
lease them to the foreign embassy for 15 years. At the end of which the flats will be transferred to
the foreign embassy for a nominal value of ₹8 lakh. Elite Builders estimates the cost of constructions
as follows:
Area per flat, 1,000 sq. feet; Construction cost, ₹ 400 per sq. feet; Registration and other costs, 2.5
per cent of cost of construction; Elite Builders will also incur ₹ 4 lakhs each in years 14 and 15 towards
repairs.
Elite Builders proposes to charge the lease rentals as follows:
Years Rentals
1 - 5 Normal
6 - 10 120 per cent of normal
11 - 15 150 per cent of normal
Elite builders present tax rate averages at 35 per cent which is likely to be the same in future. The
full cost of construction and registration will be written off over 15 years at a uniform rate and will be
allowed for tax purposes.
You are required to calculate the normal lease rental per annum per flat. For your exercise you may
assume:
(a) Minimum desired return of 10 per cent,
(b) Rentals and repairs will arise on the last day of the year, and,
(c) Construction, registration and other costs will be incurred at time = 0.

Solution:
Calculation of present value of Cash outflow: (Figure in ₹)
Cost of construction 400 x 1,000 x 6 24,00,000
Registration and other costs @ 2.5% 60,000
Cost of Repairs 4,00,000
(-) tax savings @ 35% 1,40,000
2,60,000
At t14 = Present value = 2,60,000 x 0.26333 = 68,466
At t15 = present value = 2,60,000 x 0.23939 = 62,241
1,30,707

63
 VASUDHA JAIN CLASSES – Strategic Financial Management (Group 3)

25,90,707
(Rounded of to 25,90,700)
Let 'X' be Normal lease rent per 6 flats per annum. P/V of Recurring Cash Inflow for 15 years.
Particulars 1-5 years 6-10 years 11-15 years
Lease Rent p.a. X 1.2 X 1.5 X
Depreciation (24,60,000/15) 164,000 164,000 164,000
PBT X-164,000 1.2X-164000 1.5X-164,000
PAT 65 % 0.65X-106600 0.78X-106600 0.975X-106600
CIAT = PAT + Dep. 0.65X + 57400 0.78X + 57400 0.975X + 57400
PVCF 3.7908 2.3538 1.4615
PV 2.464X + 217592 1.836X + 135108 1.425X + 83890

Leasing Decision: Total PV = 5.725 X + 436590

P/V of Terminal Cash Inflows: ₹
Nominal value of flats after 15 years 8,00,000
Less: Tax on Profit [8,00,000 x 35%] 2,80,000
Total 5,20,000
PV = 5,20,000 x 0.239 1,24,280
At 10% Rate of Return: P/V of Cash Inflows = P/V of Cash outflows
5.725X + 4,36,590 + 1,24,280 = 25,90,700
Or, X = 3,54,555.
Lease Rent per Flat = 3,54,555/6 = ₹ 59,092.50

Illustration 5 (Classroom question) New 2022 CMA MODULE QUES 12

The Sharda Beverages Ltd has taken a plant on lease, valued at ₹ 20 crore. The lease arrangement is
in the form of a leveraged lease. The Kuber Leasing Limited is the equity participant and the Hindusthan
Bank Ltd. (HBL) is the loan participant. They fund the investment in the ratio of 2:8. The loan from
HBL carries a fixed rate of interest of 19 percent, payable in 6 equated annual instalments. 'The lease
term is 6 years, with lease rental payable annually in arrear.
(a) Compute the equated annual instalment from the point or view - of HBL.
(b) If the lease rate is unknown, and HBL's per-tax yield is 25 percent, what is the minimum lease
rent that must be quoted'?

Solution:
Cost of the asset ₹ 20 cr
Debt Equity ratio 2: 8
Loan raised (20 x 8/10) = ₹ 16cr
Rate of interest 19%
(a) Computation of annual instalment
X x PVCF6yr, 19% = ₹ 16 cr.
X = ₹ 16 cr/3.4098
X = 4,69,23,573
So, equated annual instalment is ₹ 4,69,23,573
(b) Let the lease rent be X
Net outflow = Lease rent - Loan instalment = X - 46923573
Then,

64
 VASUDHA JAIN CLASSES – Strategic Financial Management (Group 3)

(X - 46923573) PVCF6yr 25% = 40000000

X = 6,04,76,463
Minimum lease rental to be quoted is ₹ 6,04,76,463.

Illustration 6 (Classroom question) New 2022 CMA MODULE QUES 13

Basic Information:
(i) Asset related: Cost ₹ 120 lacs; Depreciation 40%; Useful life 4 years; Residual value after
three years ₹ 25.92 lacs.
(ii) Leasing: Full pay out; Three-year lease; Lease Quote ₹ 434 per ₹ 1,000; Payment annually in
arrears.
(iii) Borrow and buy Three-year loan; Interest rate 15%; Quantum to be determined, such that
annual repayment of principal will be equal to annual lease rental payment.
(iv) Other: Tax Rate is 40%, and opportunity cost of capital is 11%.
Based on information given above, determine the preferred option as between leasing and buying.

Solution:
Appraisal of Leasing decision
Benefits of leasing (₹ in lakhs)
1. Saving in Investment 120.00
2. PV of tax shield on lease rentals 50.91
170.91
Cost of leasing (₹ in lakhs)
Present Value of lease rentals 118.91
PV of tax shield on depreciation 31.70
PV of tax shield on Interest 12.54
PV of terminal cash inflows (25.92 x 0.7312) 18.95
182.10
Net advantage of leasing = ₹ (170.91 -182.1) lakhs = ₹ (11.19) lakhs.
Hence, it is better to purchase the asset than to lease.
Working Notes:
1. Calculation of PV of lease rentals
Lease rent per year = 434/1000 x 120 = ₹ 52.08 lakhs
Present value lease rent = 52.08 x PVCF3yr, 15% = ₹ 118.91 lakhs
2. Present value of tax shield on lease rentals (₹ in lakhs)
Year Lease rental Tax saving PV @ 11% Present value
1 52.08 20.83 0.9009 18.7657
2 52.08 20.83 0.8116 16.9056
3 52.08 20.83 0.7312 15.2308
Total = ₹ 50.9100 lakhs

3. Present value of depreciation tax shield (₹ in lakhs)

Year Book value Depreciation Tax savings PV Present value
1 120 48 19.20 0.9009 17.2972
2 72 28.8 11.52 0.8116 9.3496
3 43.2 17.28 6.91 0.7312 5.0526

65
 VASUDHA JAIN CLASSES – Strategic Financial Management (Group 3)

4 25.92 10.368 4.147 0.6587 2.7316

4. Calculation of interest tax shield (₹ in lakhs)

Year O/ S loan Interest Installment Principal PV @ 11% Present value
1 118.91 17.835 52.08 34.245 0.9009 6.427
2 84.655 12.698 52.08 39.382 0.8116 4.122
3 45.263 6.817 52.08 45.263 0.7312 1.995
Total 12.54
Present value of terminal cash inflows = 25.92 x 0.7312 = ₹ 18.95 lakhs
Present value of lease rental = ₹ 118.91 lakhs
Interest rate @ 15%; No of instalments = 3
Instalment amount = 118.91/PVCF3yr, 15% = ₹ 52.08 lakhs

Illustration 7 (Classroom question) New 2022 CMA MODULE QUES 14

HB Finance Ltd is considering to enter the computer leasing business. Mainframe computers can be
purchased for ₹ 2,00,000 each and, in turn, be leased out at ₹ 50,000 per year for 8 years with the
initial payment occurring at the end of first year. You may ignore taxes and depreciation.
(a) Estimate the annual before tax expenses and internal rate of return (IRR) for the company.
(b) What should be the yearly lease payment charged by the company in order to earn a 20 percent
annual compounded rate of return before expenses and taxes?
(c) Assume that the firm uses the straight-line method of depreciation, there is no salvage value,
the annual expenses are ₹ 20,000, and the tax rate is 35%. Calculate the yearly lease payment
in order to enable the firm to earn 20 percent after tax annual compound rate of return.
(d) Further, assume that computer has a resale value of ₹ 40,000. Determine the revised lease
rental to enable the firm to earn 20 per cent.
Solution:
(a) Cost of the Asset ₹ 2,00,000
Life 8 years
Lease rent ₹ 50,000 p.a.
(50,000) PVCF8yr, irr ₹ 2,00,000
PVCF8yr, IRR 4
IRR 18.63%
(b) Calculation of yearly lease rent to be charged to earn 20% return
Let the yearly lease rent be X
So, X x PVCF8yr, 20% = 200000
or, X = 200000 / 3.8372
or, X = ₹ 52120
(c) Let X be the yearly lease rent
Computation of cash inflows per annum
Lease rent X
(-) annual expenses 20,000
(-) Depreciation 25,000
PBT X - 45,000
PAT @ (1-35%) 0.65X - 29,250
CIAT 0.65X - 4,250
Cash inflows after tax

66
 VASUDHA JAIN CLASSES – Strategic Financial Management (Group 3)

Present value for 8years @ 20% = (0.65X - 4250) x 3.8372 = 2,00,000

Yearly lease rent X = ₹ 86,725
(d) Present value of cash outflows
Cost of computer 2,00,000
Present value of recurring cash inflows
Lease rent X
(-) annual expenses 20,000
(-) Depreciation 20,000
PBT X - 40,000
PAT @ (1-35%) 0.65X - 26,000
CIAT 0.65X- 6000
Present value for 8years @ 20% = (0.65X-6,000) x 3.872
Present value of terminal cash inflows:
Resale value = ₹ 40,000
Its present value (40,000 x 0.23257) = ₹ 9,303
At 20%,
Inflows = Outflows (0.65x - 6,000) x 3.8372 + 9303 = 2,00,000;
Revised lease rent, X = ₹ 85,687.

Illustration 8 (Classroom question) New 2022 CMA MODULE QUES 15

Beta Ltd is considering the acquisition of a personal computer costing ₹ 50,000. The effective life of
the computer is expected to be five years. The company plans to acquire the same either by borrowing
₹ 50,000 from its bankers at 15% interest p.a. or on lease. The company wishes to know the lease
rentals to be paid annually, which match the loan option. The following further information is provided
to you:
(a) The principal amount of loan will be paid in five annual equal instalments.
(b) Interest, lease rentals, principal repayment are to be paid on the last day of each year.
(c) The full cost of the computer will be written off over the effective life of computer on a
straight-line basis and the same will be allowed for tax purposes
(d) The company's effective tax rate is 40% and the after-tax cost of capital is 9%
(e) The computer will be sold for ₹ 1,700 at the end of the 5th Year. The commission on such sales
is 9% on the sale value.
You are required to compute the annual lease rentals payable by Beta Ltd, which will result in
indifference to the loan option.

Solution:
Computation of Net Cash outflow if the Asset is Purchased by Borrowing
Tax Net
Principal Interes Installmen Tax
savings on cash Present
Year repayment t t savings on PV @ 9%
interest outflow value (₹)
(₹) (₹) (₹) dep (₹)
(₹) (₹)
1 10,000 7,500 17,500 3,000 4,000 10,500 0.91743 9,633
2 10,000 6,000 16,000 2,400 4,000 9,600 0.84168 8,080
3 10,000 4,500 14,500 1,800 4,000 8,700 0.77218 6,718
4 10,000 3,000 13,000 1,200 4,000 7,800 0.70843 5,526
5 10,000 1,500 11,500 600 4,000 6,900 0.64993 4,485

67
 VASUDHA JAIN CLASSES – Strategic Financial Management (Group 3)

Present Value of Total outflow of cash ₹ 34,442

Less: Present value of terminal cash inflows:
Sale value of asset ₹ 1,700
(-) Commission ₹ 153
₹ 1,547
(-) Tax on profit @ 40% ₹ 619
₹ 928
Its Present value ₹ (928 x 0.64993) ₹ 603
Net cash outflow = 34,442 - 603 = ₹ 33,839
Since we are required to find the annual lease rental payable, which will result in indifference to loan
option. The present value of net cash outflow will be the same in each case.
Computation of break-even lease rent:
Let X be the break-even lease rent
Present value of cash inflows:
Lease rent ₹X
(-) Tax saving (X @ 40%) ₹ 0.4X
Lease rent after tax per year ₹ 0.6X
Present value of lease rental for five years = (0.6X) x (3.8896) = 33,839
or, X = ₹ 14,500.
So, the required annual lease rental is ₹ 14,500.

Illustration 9 (Classroom question) New 2022 CMA MODULE QUES 16

ABC leasing Ltd. is in the process of making out a proposal to lease certain equipment. The cost of the
equipment is ₹ 10,00,000 and the period of lease is 10 years. The following additional information is
available. You are required to determine the equated annual rent to be charged for the proposal.
(a) The ma chine can be depreciated fully over the 10 years on straight-line basis
(b) The current effective tax rate is 40% and expects to go down to 30% from the beginning of
the 6th year of the lease.
(c) It is the normal objective to make a 10% post-tax return in its lease pricing
(d) Lease management fee of 1% of the value of the assets is usually collected from the lessees
upon signing of the contract of lease, to cover the overhead costs related to processing of the
proposal.
(e) Annual lease rents are collected at the beginning of every year.

Solution:
Present value of cash outflow:
Cost of equipment ₹ 10,00,000
Let X be the equated annual lease rent
Present value of lease rentals after tax (Figures in ₹)
Year Lease rent Tax Net cash inflows PV @ 10% Present value
0 X - X 1.0000 X
1-5 X 0.4X 0.6X 3.7908 2.2745X
6-9 X 0.3X 0.7X 1.9680 1.3776X
10 0 0.3X (0.3X) 0.3855 (0.1158X)
Present value of total recurring cash inflows = 4.5364X

68
 VASUDHA JAIN CLASSES – Strategic Financial Management (Group 3)

Calculation of tax shield on depreciation (Figures in ₹)

Year Depreciation Tax benefit PV @ 10 % Present value
1-5 1,00,000 40,000 3.7908 1,51,600
6-10 1,00,000 30,000 2.3540 70,620
2,22,220
At 10%, Inflows = Outflows
Or, 1000000 = 4.5364X + 222220
X = 1,71,453.
Therefore, equated annual rent is ₹ 1,71,453.

Illustration 10 (Classroom question) New 2022 CMA MODULE QUES 1

Excel Transport needs a truck for which it is considering the following two options:
(i) Buy the asset for ₹ 3,00,000 by borrowing the amount @ 12% interest and repaying the same
together with interest in 4 equal annual instalments.
(ii) Acquiring the asset on lease with a payment of annual lease rentals of ₹ 90,000 per annum for
4 years.
The firm follows straight line method of depreciation and is under the income tax bracket of 30%. Life
of the asset is 4 years.
Which option - lease or buy, should the firm opt for?

Solution:
Applicable discount rate = 12(1-0.3) = 8.4% p.a.
Lease Option:
Present value of after-tax lease rentals = 90,000 x (1-0.3) x PVIFA (8.4%, 4 years)
= 63,000 x 3.28 = ₹ 2,06,640
Buy Option
Annual instalment = 3,00,000 ÷ PVIFA (12%, 4) = 3,00,000 ÷ 3.037 = ₹ 98,782
Calculation of interest tax shield (in ₹)
Tax
Opening Interest Closing PVIF @ PV of tax
Instalment Principal savings on
outstanding @ 12% Outstanding 8.4% savings
Interest
3,00,000 36,000 98,782 62,782 2,37,218 10,800 0.9225 9,963
2,37,218 28,466 98,782 70,316 1,66,902 8,540 0.8510 7,268
1,66,902 20,028 98,782 78,754 88,148 6,008 0.7851 4,717
88,148 10,634 98,782 88,148 0 3,190 0.7242 2,310
Total 24,258

Calculation of depreciation tax shield (in ₹)

Depreciation Tax savings PVIF @ 8.4% PV of tax savings
75,000 22,500 0.9225 20,756
75,000 22,500 0.8510 19,148
75,000 22,500 0.7851 17,665
75,000 22,500 0.7242 16,295
73,864

69
 VASUDHA JAIN CLASSES – Strategic Financial Management (Group 3)

Present value of cash flow under buy option

Particulars ₹
Present value of instalments (98,782 x 3.2828) 3,24,282
Less: Interest tax shield 24,258
Less: Depreciation tax shield 73,864
Total 2,26,160
Since the present value of net cash outflow under leasing option is lower than that of buy option, leasing
is preferable to buy option.
Alternative Approach of Calculation (Buy Option) (in ₹)

Tax
Tax PVIF
Interest Savings PV of
Year Installment Depreciation Savings NCF @
@ 12% on NCF
on Dep. 8.4%
Interest
1 98,782 36,000 10,800 75,000 22,500 65,482 0.9225 60,407
2 98,782 28,466 8,540 75,000 22,500 67,742 0.8510 57,648
3 98,782 20,028 6,008 75,000 22,500 70,274 0.7851 55,172.11
4 98,782 10,634 3,190 75,000 22,500 73,092 0.7242 52,933
2,26,160
Since the present value of net cash outflow under leasing option is lower than that of buy option, leasing
is preferable to buy option.

Illustration 11 (Classroom question) New 2022 CMA MODULE QUES 2

Sigma Ltd. is proposing to acquire special purpose machinery. The initial cost of machine is ₹ 8,00,000.
Depreciation allowance is given @ 20% p.a. on reducing balance method. To finance the entire cost, the
company intend to get a loan of ₹ 8,00,000 on interest @ 18% p.a.
Another proposal has come for review to take the same machinery on lease basis on annual lease rentals
of ₹ 2,40,000 for a period of 5 years. How would the acquisition of assets under the above two
alternatives effect the Profit and Loss Account and Balance Sheet? The Profit and Loss Account and
the Balance Sheet of Sigma Ltd. before the acquisition are given below:
Profit and Loss Account of Sigma Ltd.
Particulars ₹ Particulars ₹
To Administrative & Other exp. 18,00,000 By Gross Profit 28,00,000
To Net Profit 10,00,000
28,00,000 28,00,000

Balance Sheet of Sigma Ltd.

Liabilities ₹ Assets ₹
Equity 14,00,000 Fixed Assets 12,00,000
Current Liabilities 6,00,000 Current Assets 8,00,000
20,00,000 20,00,000

Solution:
(a) Effects on Profit and Loss Account
(i) When asset is purchased outright by taking a loan
Profit and Loss Account of Sigma Ltd.

70
 VASUDHA JAIN CLASSES – Strategic Financial Management (Group 3)

Particulars ₹ Particulars ₹
To Administrative & Other exp. 18,00,000
To Interest on loan (@ 18% on ₹ 8,00,000) 1,44,000
To Depreciation on machinery (@ 20% on ₹ 8,00,000) 1,60,000
To Net Profit 6,96,000 By Gross Profit 28,00,000
28,00,000 28,00,000

(ii) When asset is taken on lease

Profit and Loss Account of Sigma Ltd.
Particulars ₹ Particulars ₹
To Administrative & Other exp. 18,00,000 By Gross Profit 28,00,000
To Lease Rent 2,40,000
To Net Profit 7,60,000
28,00,000 28,00,000

(a) Effects on Balance Sheet

(i) When asset is purchased outright by taking a loan
Balance Sheet of Sigma Ltd.
Liabilities ₹ Assets ₹
Equity 14,00,000 Fixed Assets (12,00,000+8,00,000) 20,00,000
Debt 8,00,000 Current Assets 8,00,000
Current Liabilities 6,00,000
28,00,000 28,00,000

(ii) When asset is taken on lease

Balance Sheet of Sigma Ltd.
Liabilities ₹ Assets ₹
Equity 14,00,000 Fixed Assets 12,00,000
Current Liabilities 6,00,000 Current Assets 8,00,000
20,00,000 20,00,000

Illustration 12 BELR from the point of view of a lessee (Classroom question)

New 2022 CMA MODULE QUES 3
Excel Transport needs a truck for which it is considering the following two options:
(i) Buy the asset for ₹ 3,00,000 by borrowing the amount @ 12% interest and repaying the
same together with interest in 4 equal annual instalments.
(ii) Acquiring the asset on lease with a payment of annual lease rentals for 4 years.
The firm follows straight line method of depreciation and is under the income tax bracket of 30%. Life
of the asset is 4 years.
What is the maximum amount the lessee will be willing to pay for accepting the lease?

Solution:
Refer to Illustration 1 for detail calculation.
Present value of cash flow under buy option
Particulars ₹
Present value of instalments (98,782 x 3.2828) 3,24,282

71
 VASUDHA JAIN CLASSES – Strategic Financial Management (Group 3)

Less. Interest tax shield 24,258

Less. Depreciation tax shield 73,864
Total 2,26,160
Let the break-even lease rental is ₹ X.
Applicable discount rate = 12(1-0.3) = 8.4% p.a.
So, Present value of after-tax lease rental = ₹ X x (1- tax rate) x PVIFA (8.4%, 4 years)
= ₹ X x (1- 0.30) x 3.2828 = ₹2.29796X
Conditionally, 2.29796X = 2,26,160
So, X = 98,417
So, the maximum amount the lessee will be willing to pay for accepting the lease (i.e., BELR) is ₹ 98,417.

Illustration 13 BELR from the point of view of a lessor (Classroom question)

New 2022 CMA MODULE QUES 4 4
ABC finance, a leasing company, has been approached by a prospective customer intending to acquire a
machine whose Cash Down price is ₹ 6 crores. The customer, in order to leverage his tax position, has
requested a quote for a four-year lease with rentals payable at the end of each year but in a diminishing
manner such that they are in the ratio of 4: 3: 2: 1. Depreciation can be assumed to be on straight line
basis and ABC Finance's marginal tax rate is 30%. The target rate of return for ABC Finance on the
transaction is 10% p.a. The asset has no salvage value.

Solution:
Applicable discount rate = 10 (1-0.3) = 7.0% p.a.
Cost of the asset = ₹ 6 crores.
Depreciation under SLM = ₹ 6 crores ÷ 4 years = ₹ 1.5 crores.
PV of depreciation tax shield
= ₹ 1.5 crores x 0.30 x PVIFA (7%, 4 years)
= ₹ 1.5 crores x 0.30 x 3.387
= ₹ 1.52415 crores
Let the amount to be quoted by ABC Finance (i.e., break-even lease rental) is ₹ X for fourth year. So,
Present value of after lease rental revenue will be:
Year Post-tax Rental PVIF @ 7% PV of post-tax rental
1 4X x (1-0.3) 0.935 2.618X
2 3X x (1-0.3) 0.873 1.8333X
3 2X x (1-0.3) 0.816 1.1424X
4 X x (1-0.3) 0.763 0.5341X
Total 6.1278X
Conditionally, 6.1278X = 6,00,00,000 - 1,52,41,500 or, X = 73,04,171
So, the lease rentals to be quoted are ₹ 2,92,16,684, ₹ 2,19,12,513, ₹ 1,46,08,342 and ₹ 73,04,171

Illustration 14 BELR in case of Leveraged Lease (Classroom question)

New 2022 CMA MODULE QUES 5 4
P Ltd has taken a plant on lease, valued at ₹ 20 crore. The lease arrangement is in the form of a
leveraged lease. K Ltd. is the equity participant and the H Ltd. is the loan participant. They invested

72
 VASUDHA JAIN CLASSES – Strategic Financial Management (Group 3)

fund in the ratio of 1:4. The loan from H Ltd. carries a fixed rate of interest of 15 percent, payable in
6 equated annual instalments. The lease term is 6 years, with lease rental payable annually in arrear.
(a) Compute the equated annual instalment from the point or view of H Ltd.
(b) If the lease rate is unknown, and H Ltd.'s pre-tax yield is 20 percent, what is the minimum lease
rent that must be quoted₹
Solution:
Cost of asset = ₹ 40 crores
Debt-equity ratio = 1:4
Loan raised = ₹ 40 x 4/5 = ₹ 32 crores
Rate of interest = 15% p.a.
(a) Let the equated annual instalment = ₹ X
Conditionally, X x PVIFA (15%, 6 years) = 32
or, 3.7845X = 32
or, X = 32/3.7845
or, X = 8.4555423 Crore = ₹ 8,45,55,423
So, the equated annual instalment is ₹ 8,45,55,423.
(b) Let the lease rental be ₹ Y
Equity component of the cost of asset = ₹ 40 x 1/5 = ₹ 8 crores
So, Net cash flow = Lease rental - Loan instalment = ₹ (Y - 8,45,55,423)
Conditionally, (Y - 8,45,55,423) x PVIFA (20%, 6 years) = 8,00,00,000
or, (Y - 8,45,55,423) x 3.3255 = 8,00,00,000
or, Y - 8,45,55,423 = 2,40,56,533 or, Y = 10,86,11,956
So, the minimum lease rent that must be quoted by H Ltd. is ₹ 10,86,11,956.

Illustration 15 (Classroom question) New 2022 CMA MODULE QUES 6 4

Lessor charges ₹ 5,000 annually, paid directly to the lessor at the start of each year
Lease commencement: 1/1/2020
Lease end date: 12/31/2024
Lease term: 5 years
The fair value of the tractor at lease commencement: ₹ 20,000
The lessor expects the fair value of the tractor at the end of the 5-year lease term (the unguaranteed
residual value) will be ₹ 1,000
Lessor incurs initial direct costs of 1,500
Calculate the interest rate implicit in the lease.

Solution:
Implicit rate is the rate (say r) for which,
PV of Lease payments + PV of unguaranteed residual value = Fair value of underlying asset + Initial
direct costs of the lessor
or, 5000 x PVIFA (r%, 5 years) + 1000 x PVIF (r%, 5 years) = 20000 + 1500
Solving the above equation for r, we get r = 9.92%.
So, the interest rate implicit in the lease is 9.92% p.a.

Illustration 16 (Classroom question) New 2022 CMA MODULE QUES 7 4

(a) Equal Periodic Plan
Majestic Transport needs a machine for which it is considering the following two options:

73
 VASUDHA JAIN CLASSES – Strategic Financial Management (Group 3)

(i) Buy the asset for ₹ 6,00,000 by borrowing the amount @ 12% interest and repaying the
same together with interest in 4 equal annual instalments.
(ii) Acquiring the asset on lease with a payment of annual lease rentals for 4 years.
The firm follows straight line method of depreciation and is under the income tax bracket
of 30%. Life of the asset is 4 years.
If Majestic Transport is willing to opt for equal annual plan for lease rental, what will be the
lease rental payable?

Solution:
Applicable discount rate = 12(1-0.3) = 8.4% p.a.
Buy Option
Annual instalment = 6,00,000 ÷ PVIFA (12%, 4) = 6,00,000 ÷ 3.037 = ₹ 1,97,564
Calculation of interest tax shield (Figures in ₹)
Opening Interest Closing Tax PVIF @ PV of tax
Instalment Principal
outstanding @ 12% Outstanding savings 8.4% savings
6,00,000 72,000 1,97,564 1,25,564 4,74,436 21,600 0.9225 19,926
4,74,436 56,932 1,97,564 1,40,632 3,33,804 17,077 0.8510 14,533
3,33,804 40,056 1,97,564 1,57,508 1,76,296 12,017 0.7851 9,435
1,76,296 21,268 1,97,564 1,76,296 0 6,380 0.7242 4,620
Total 48,514

Calculation of depreciation tax shield (Figures in ₹)

Depreciation Tax savings PVIF @ 8.4% PV of tax savings
1,50,000 45,000 0.9225 41,513
1,50,000 45,000 0.8510 38,295
1,50,000 45,000 0.7851 35,330
1,50,000 45,000 0.7242 32,589
1,47,727

Present value of cash flow under buy option

Particulars ₹
Present value of instalments (1,97,564 x 3.2828) 6,48,563
Less. Interest tax shield 48,514
Less. Depreciation tax shield 1,47,727
Total 4,52,322
Determination of lease rental payable under Equated Annual Plan
Let the (break-even) lease rental is ₹ X.
Applicable discount rate = 12(1-0.3) = 8.4% p.a.
So, Present value of after-tax lease rental
= ₹ X x (1- tax rate) x PVIFA (8.4%, 4 years)
= ₹ X x (1- 0.30) x 3.2828 = ₹ 2.29796X
Conditionally, 2.29796X = 4,52,322
So, X = 1,96,836
So, the maximum amount the lessee will be willing to pay for accepting the lease under an equal periodic
plan (i.e., BELR) is ₹ 1,96,836.

74
 VASUDHA JAIN CLASSES – Strategic Financial Management (Group 3)

(b) Stepped-up Plan

Refer to the previous information. Assume that the lessor wants the rental to be in the ratio of 4:3:2:1.
Calculate the lease rental.
Solution:
Present value of cash flow under buy option = ₹ 4,52,322
Present value of the after-tax lease rental (Figures in ₹)
Lease
Year After tax lease rental PVIF @ 8.4% PV of after-tax lease rental
rental
1 4X 4X (1-0.30) = 2.8X 0.9225 2.583X
2 3X 3X (1-0.30) =2.1X 0.8510 1.7871X
3 2X 2X (1-0.30) =1.4X 0.7851 1.09914X
4 X X (1-0.30) =0.7X 0.7242 0.50694X
Total 5.97618X
Conditionally, 5.97618X = 4,52,322
or, X = 75,687
So, the lease rental for 4th year = ₹ 75,687; for 3rd year = ₹ 1,51,374;
for 2nd year = ₹ 2,27,061 and for 1st year = ₹ 3,02,748.

(c) Stepped-down Plan

Refer to the previous information. Assume that the lessor wants the rental to be in the ratio of 1:2:3:4.
Calculate the lease rental.
Solution:
Present value of cash flow under buy option = ₹ 4,52,322
Present value of the after-tax lease rental (Figures in ₹)
After tax lease
Year Lease rental PVIF @ 8.4% PV of after-tax lease rental
rental
1 X X (1-0.30) = 0.7X 0.9225 0.64575X
2 2X 2X (1-0.30) =1.4X 0.8510 1.1914X
3 3X 3X (1-0.30) =2.1X 0.7851 1.64871X
4 4X 4X (1-0.30) =2.8X 0.7242 2.02776X
Total 5.51362X
Conditionally, 5.51362X = 4,52,322 or, X = 82,037
So, the lease rental for 1st year = ₹ 82,037; for 2nd year = ₹ 1,64,074; for 3rd year = ₹ 2,46,111; for
4th year = ₹ 3,28,148.

(d) Balloon Payment Plan - it may be similar to a stepped-up plan.

(e) Deferred Payment Plan
Refer to the previous information. Assume that the lessee requires a plan to pay nothing in the first
year and pay the rest equally in the remaining three years.
Solution:
Present value of cash flow under buy option = ₹ 4,52,322
Present value of the after-tax lease rental (Figures in ₹)
After tax lease
Year Lease rental PVIF @ 8.4% PV of after-tax lease rental
rental
1 0 0 0.9225 0

75
 VASUDHA JAIN CLASSES – Strategic Financial Management (Group 3)

2 X X (1-0.30) =0.7X 0.8510 0.5957X

3 X X (1-0.30) =0.7X 0.7851 0.54957X
4 X X (1-0.30) =0.7X 0.7242 0.50694X
Total 1.65221X
Conditionally, 1.65221X = 4,52,322
or, X = 2,73,768
So, from the second year onwards, the lessee is required to pay ₹ 2,73,768 per year for three
consecutive years.

Illustration 17 (HOMEWORK QUESTION) New 2022 CMA MODULE QUES 8

A factory needs an equipment for use. It has the option of outright purchase or leasing the equipment.
Data are given below. Recommend the best option that the factory should choose.
Option I
Purchase outright for a cost of ₹ 80 lakhs. It is to be entirely financed by a term loan @ 18% p.a.
interest on outstanding payable on a yearly basis. The term loan to be repaid in eight equal instalments
of ₹ 10 lakhs each, beginning from second year-end. The economic life of the equipment is assessed to
be ten years. The equipment will be depreciated @ 10% p.a. on straight line basis, with insignificant
salvage value at the end of the economic life? The estimated maintenance expenses would be as detailed
below:
Year 1 2 3 4 5 6 7 8 9 10
MC* 4.00 4.40 4.88 5.47 6.18 7.05 8.11 9.41 11.01 13.00
*MC = maintenance cost in ₹ Lakhs

Option II
The equipment may be leased for a ten-year period. The maintenance of the equipment will be done by
the lessor. The lessee has to pay ₹18 lakhs annual rental at the beginning of each year over the lease
period.
Note - Assume that the lessee is in a tax bracket of 50% and average cost of capital of the lessee
firm as 14% p.a.

Solution:
Option I: Purchase (₹ in lakhs)
Loan Amount Tax Outflow Total
Year Interest MC Int. + MC+ Dep.
repaid balance Savings Int. +MC Outflow
1 - 80 14.40 4.00 26.40 13.20 5.20 5.20
2 10 70 14.40 4.40 26.80 13.40 5.40 15.40
3 10 60 12.60 4.88 25.48 12.74 4.74 14.74
4 10 50 10.80 5.47 24.27 12.13 4.14 14.14
5 10 40 9.00 6.18 23.18 11.59 3.59 13.59
6 10 30 7.20 7.05 22.25 11.13 3.13 13.12
7 10 20 5.40 8.11 21.51 10.76 2.76 12.75
8 10 10 3.60 9.41 21.01 10.50 2.50 12.50
9 10 0 1.80 11.01 20.81 10.41 2.40 12.41
10 - -- - 13.00 21.00 10.50 2.50 2.50

76
 VASUDHA JAIN CLASSES – Strategic Financial Management (Group 3)

Calculation for Present Values

Year Total Cash Outflow PVIF @ 14% PV of Cash Outflow
1 5.20 0.877 4.56
2 15.40 0.769 11.84
3 14.74 0.675 9.95
4 14.14 0.592 8.37
5 13.59 0.519 7.05
6 13.12 0.465 6.10
7 12.75 0.400 5.10
8 12.50 0.351 4.39
9 12.40 0.308 3.82
10 2.50 0.270 0.68
Total 61.86

Option II: Lease (₹ in lakhs)

Year Lease rent Lease rent after tax PVIF @14% Present Value
1 18 9 1.000 9.00
2 18 9 0.877 7.89
3 18 9 0.769 6.92
4 18 9 0.675 6,07
5 18 9 0.592 5.33
6 18 9 0.519 4.67
7 18 9 0.465 4.19
8 18 9 0.400 3.60
9 18 9 0.351 3.16
10 18 9 0.308 2.77
Total present value of cash outflows = 53.60
Comment: The present value of net cash flows is lowest for lease option; hence it is suggested to take
equipment on lease basis.

77