Illustration 3: BELR from the point of view of a lessee

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 × 3.2828) 3,24,282
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% [Link], Present value
of after-tax lease rental
= `X × (1- tax rate) × PVIFA (8.4%, 4 years)
= `X × (1- 0.30) × 3.2828
= `2.29796X
Conditionally, 2.29796X = 2,26,160So, 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 4: BELR from the point of view of a lessor

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 [Link] of
depreciation tax shield

= `1.5 crores × 0.30 × PVIFA (7%, 4 years)

= `1.5 crores × 0.30 × 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 × (1-0.3) 0.935 2.618X
2 3X × (1-0.3) 0.873 1.8333X
3 2X × (1-0.3) 0.816 1.1424X
4 X × (1-0.3) 0.763 0.5341X
Total 3.387 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 5: BELR in case of Leveraged Lease

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 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 termis 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 mustbe
quoted?
Solution:
Cost of asset = `40 crores
Debt-equity ratio = 1:4
Loan raised = `40 × 4/5 = `32 crores
Rate of interest = 15% p.a.
(a) Let the equated annual instalment = ` X
Conditionally, X ×PVIFA (15%, 6 years) = 32or,
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 × 1/5 = `8 crores
So, Net cash flow = Lease rental - Loan instalment = `(Y - 8,45,55,423)
Conditionally, (Y - 8,45,55,423) × PVIFA (20%, 6 years) = 8,00,00,000
or, (Y - 8,45,55,423) × 3.3255 = 8,00,00,000
or, Y - 8,45,55,423 = 2,40,56,533or,
Y = 10,86,11,956

So, the minimum lease rent that must be quoted by H Ltd. is `10,86,11,956.
 Illustration 7

(a) Equal Periodic Plan

Majestic Transport needs a machine for which it is considering the following two options:
(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
Opening Interest Instalment Principal Closing Tax PVIF @ PV of tax
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

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 × 3.2828) 6,48,563
Less. Interest tax shield Less. 48,514
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% [Link], Present
value of after-tax lease rental
= ` X × (1- tax rate) × PVIFA (8.4%, 4 years)
= ` X × (1- 0.30) × 3.2828
 = ` 2.29796X
Conditionally, 2.29796X = 4,52,322So,
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.
(b) Stepped-up Plan
Refer to the previous information. Assume that the lessor wants the rental to be in the ratio of [Link]. 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 `)
Year Lease rental After tax lease rental PVIF @ 8.4% PV of after-tax lease 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 [Link]. Calculate the
lease rental.

Solution:
Present value of cash flow under buy option = `4,52,322
Present value of the after-tax lease rental
Year Lease rental After tax lease rental PVIF @ 8.4% PV of after-tax lease 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
Year Lease rental After tax lease rental PVIF @ 8.4% PV of after-tax lease rental
1 0 0 0.9225 0
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.

Additional Illustrations
1. 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)

Year Loan Amount Interest MC Int. + MC+ Tax Outflow Total

repaid balance Dep. 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
 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.
2. 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 marginaltax 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 × 0.35 × PVIFA (12%, 3 years) = 35 × 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 × (1 – .35) = 1.95x 1.95 × (1/1.12) = 1.7411x
2
2 2x × (1 – .35) = 1.3x 1.30 × [(1/(1.12) ] = 1.0364x
3
3 x × (1 – .35) = 0.65x 0.65 × [1/(1.12) ] = 0.4626x
= 3.2401x
 Therefore 3.2401 x = 215.94or, x =
`66.6409 lakhs
Year-wise rentals are as follows: (` in lakhs)
Year 1 3 × 66.6409 lakhs 199.9227
Year 2 2 × 66.6409 lakhs 133.2818
Year 3 1 × 66.6409 lakhs 66.6409
3, 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 atan 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 [Link]
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 aperiod
of ten years
The present value of one Rupee due at the end of each year is

End of
1 2 3 4 5 6 7 8 9 10
year
Present 0.86207 0.74316 0.64066 0.55229 0.47611 0.41044 0.35313 0.30503 0.26295 0.22668
Value

Solution:
ABC Company Ltd
Appraisal of Buying Decision: PV of Cash Out Flows (Fig in `)
Principal Tax savings Tax savings Net cash PV factor Present
Year Interest Outflow
repayment on dep. on int. out flow @ 16% value
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
Lease rent per year is 320/1,000 × 1,00,000 = `32,000
Year Lease rent (`) Tax savings (`) Net out flow (`) PVCF @ 16% Present value (`)
1-5 32,000 16,000 16,000 3.27429 52,390
PVCF = Present Value of Cashflow
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 annualcash
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.

4, 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 ofcost 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 taxpurposes.
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 × 1,000 × 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 × 0.26333 68,466
At t15 = present value = 2,60,000 × 0.23939 62,241 1,30,707
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 × 35%] 2,80,000
Total 5,20,000
PV = 5,20,000 × 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

5, 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 thatmust be
quoted‟?
Solution:
Cost of the asset `20 cr
Debt Equity ratio 2: 8
Loan raised (20 × 8/10) = `16cr
Rate of interest 19%
(a) Computation of annual instalment
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,
(X – 46923573) PVCF6yr, 25% = 40000000
X = 6,04,76,463

Minimum lease rental to be quoted is `6,04,76,463.

 6, 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 × 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 × 120 = ` 52.08 lakhs

Present value lease rent = 52.08 × 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 @11% 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
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 × 0.7312 = `18.95 lakhs Present value of lease rental = `118.91lakhs

Interest rate @ 15%; No of instalments = 3

Instalment amount = 118.91/PVCF 3yr, 15% = `52.08 lakhs

7, 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% returnLet the
yearly lease rent be X
So, 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 annumLease 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
Present value for 8years @ 20% = (0.65X – 4250) × 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) × 3.872
Present value of terminal cash inflows:
Resale value = `40,000
Its present value (40,000 × 0.23257)= `9,303
At 20%,
Inflows = Outflows
(0.65x – 6,000) × 3.8372 + 9303 = 2,00,000;
Revised lease rent, X = `85,687.

8, 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
Principal Tax Tax Net cash
Interest Installment PV @ Present
Year repayment savings on savings on outflow
(`) (`) 9% value (`)
(`) interest (`) 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
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 × 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 [Link]
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) × (3.8896) = 33,839

or, X = `14,500.
So, the required annual lease rental is `14,500.

9, 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 6 th 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 signingof 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

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.

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:0
a) Depreciation: ` (22,00,000 – 10,00,000)/3 = ` 4,00,000 p.a.
b) Effective rate of interest after tax shield: 0.16 × (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%;
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 fa ctor 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 × 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.