TERM LOAN S AND LEASE FINAN CING Chapter 3 67

Illustrative Problems
ILLUSTRATION 1. A Company is trying to decide between leasing and buying a new
equipment. The company can lease the equipment for five years, making annual payments of
Rs 16,378 per year or they can buy the equipment for Rs 50,000. At the end of fifth year, the
equipment will have salvage value of Rs 10,000. The firm's cost of capital is 10 percent with a
before tax cost of debt of 8 percent. The company uses straight-line depreciation and has a
50 percent tax rate.
Analyze whether the company should lease or buy. Use the after-tax cost of debt as a
discount factor and obtain the result using schedules.
SOLUTION
Given,
Cost of equipment = Rs 50,000
Number of years = 5 years
Salvage value = Rs 10,000
Cost of capital = 10 percent
Before tax cost of debt = 8 percent
After tax cost of debt = 8% (1 0.50) = 4%
Tax rate = 50%
Lease rent (Lt) = Rs 16,378
Depreciation = = Rs 8,000 per year
Calculation of installment = = = = Rs 12,522.85
Alternative 1: Leasing
Calculation of PV of after tax cash outflow under leasing alternative
Lease Tax saving on After tax lease Present
Year PVIFA at 4%
rent lease rent rent value
15 Rs 16,378 Rs 8,189 Rs 8,189 4.4518 Rs 36,455.79
Alternative 2: Purchasing
Preparation of loan amortization schedule
Year Installment Rs Interest in Rs Principal payment in Rs Balance in Rs
0 - - - 50,000
1 12,522.85 4,000 8,522.85 41,477.15
2 12,522.85 3,318.17 9,204.68 32,272.47
3 12,522.85 2,581.80 9,941.05 22,331.42
4 12,522.85 1,786.51 10,736.34 11,595.08
5 12,522.85 927.77 11,595.08 -
Calculation of after tax cash outflow
Tax savings on After tax
After tax
Year Installment Interest Depreciation int. & dep. (Int. salvage value
cash flow
+ Dep.) T
1 12,522.85 4,000 Rs 8,000 Rs 6,000 Rs 6,522.85
2 12,522.85 3,318.17 8,000 5,659.09 6,863.76
3 12,522.85 2,581.80 8,000 5,290.90 7,231.95
4 12,522.85 1,786.51 8,000 4,893.26 7,629.59
5 12,522.85 927.77 8,000 4,463.89 Rs 10,000 (1,941.04)
PV of after tax cash outflow under buying and borrowing
Year After tax cash flow (Rs ) Factor @ 4% Present value (Rs )
1 Rs 6,522.85 0.9615 6,271.72
2 6,863.76 0.9246 6,346.232
3 7,231.95 0.8890 6,429.204
4 7,629.59 0.8548 6,521.774
5 (1,941.04) 0.8219 (1,595.34)
PV of after tax cash outflow under purchase alternative 23,973.59
68 Chapter 3 C A P I T AL STRUC TURE MANAGEMENT
Decision: The company is advised to go for buying of equipment, as the PV of cash outflows under
buying alternative is lower than that under leasing alternative.
ILLUSTRATION 2. A Tool Company is attempting to determine whether to lease or purchase a
new conveyor system. The firm is in the 40 percent tax bracket and the after-tax cost of debt
is currently 6 percent. The terms of the lease and the purchase are given below:
Lease: Annual advance lease payments of Rs 19,744 are required over its four year life. The
lease payment is one deductible for tax purposes until the service is actually received.
Purchase: The conveyor costing Rs 70,000 could be purchased. Straight-line depreciation
and not salvage value would be used. The purchase would be financed with a Rs 70,000, 9
percent loan requiring four annual end of year payments of Rs 21,607.
a. Calculate the after-tax cash outflows associated with each alternative.
b. Calculate the present value of each of these cash flow streams by using the after-tax
cost of debt.
c. Which alternative would you recommend? Explain.
SOLUTION
Given,
Tax rate (T) = 40%
After-tax cost of debt (kdT) = 6%
Lease:
Lease payment (Lt) = Rs 19,744
Lease period (n) = 4 years
Purchase:
Cost of machine (I0) = Rs 70,000
Depreciation = Straight line
Salvage value (SVn) =0
Interest rate (kd) = 9%
Loan installment (PMT) = Rs 21,607
Number of years (n) = 4 years
a. Calculation of after-tax cash outflows associated with each alternative
(i) Lease alternative
Year Lease rent Tax shield 40% After-tax cash flows
0 Rs 19,744 - Rs 19,744
1 19,744 Rs 7,897.60 11,846.40
2 19,744 7,897.60 11,846.40
3 19,744 7,897.60 11,846.40
4 7,897.60 (7,897.60)
(ii) Purchase alternative
Calculation of after-tax cash outflow
Tax savings on int. & dep. After tax cash
Year Installment Interest Depreciation
(Int. + Dep.) T flow
1 Rs 21,607 Rs 6,300 Rs 17,500 Rs 9,520 Rs 12,087
2 21,607 4,922.37 17,500 8,968.95 12,638.05
3 21,607 3,420.75 17,500 8,368.30 13,238.7
4 21,607 1,783.99 17,500 7,713.60 13,893.4
Working notes:
(i) Preparation of amortization schedule
Installment Interest Principal Loan outstanding
Year
(Rs ) (Rs ) (Rs ) (Rs )
0 Rs 70,000
1 Rs 21,607 Rs 6,300 Rs 15,307 54,693
2 21,607 4,922.37 16,684.63 38,008.37
3 21,607 3,420.75 18,186.25 19,822.12
4 21,607 1,783.99 19,823.01
(ii) Calculation of depreciation
 TERM LOAN S AND LEASE FINAN CING Chapter 3 69
Annual depreciation = = = Rs 17,500 per year
b. Calculation of Present value of after-tax cash flow using after-tax cost of debt for
each alternative.
(i) Lease alternative
Year After-tax cash flows PV factor at 6% Present value of cash flows
0 Rs 19,744 Rs 1 Rs 19,744
1 11,846.40 0.9434 11,175.89
2 11,846.40 0.8900 10,543.30
3 11,846.40 0.8396 9,946.24
4 (7,897.60) 0.7921 (6,255.69)
PV of after-tax cash outflow Rs 45,153.74
(ii) Purchase alternative
PV of after-tax cash outflow under buying and borrowing
Year After-tax cash flow Factor @ 6% Present value
1 Rs 12,087 0.9434 Rs 11,402.88
2 12,638.05 0.8900 11,247.86
3 13,238.70 0.8396 11,115.21
4 13,893.40 0.7921 11,004.96
PV of after-tax cash outflow under purchase alternative Rs 44,770.91
c. Purchasing alternative should be preferred to leasing as it involves less cash outflows.
ILLUSTRATION 3. Nepal Leasing Company wishes to acquire an asset of Rs 100,000. It has a
useful life of 8 years. At the end of this time, its scrap value will be Rs 8,000. The asset falls
into the 5-year property class for cost recovery (depreciation) purposes under MACRS. The
Company can use either lease or debt financing; lease payments of Rs 16,000 at the
beginning of each of the 8 years would be required. If debt financed, the interest rate would
be 14 percent paid payment would be due at the beginning of each of the 8 years. (Interest
would be amortized as a mortgage type of debt instrument). The company is in a 40 percent
tax bracket. Which method of financing has the lower present value of cash outflows?
Depreciation under MACRS:
Year 1 2 3 4 5 6
Depreciation rate 0.20 0.32 0.19 0.12 0.11 0.06
SOLUTION
Given,
Cost of assets = Rs 100,000
Life of asset = 8 years
Scrap value = Rs 8,000
Property class = 5 years
Annual advance lease rent = Rs 16,000
Interest rate on debt = 14%
Installment payment = Advance
Tax rate = 40%
We have,
After tax cost of debt (kdt) = kd (1 t) = 14 (1 0.40) = 8.4%
Calculation of present value of leasing, PV(L)
We have,
PV (L) = L0 + Lt (1 T) PVIFAkdt, n-1 Lt T PVIFkdt, n
= 16,000 + 16,000 (1 0.4) PVIFA 8.4%, 7 16000 0.4 PVIF 8.4%, 8
= 16,000 + 9600 5.1359 6400 0.5245
= 16000 + 49304.64 3356.8
= Rs 61,947.84
Calculation of the PV of borrow purchase, PV (P)
First calculate the payment or loan installment]
We have,
PVA = PMT PVIFAkd, n (1 + kd)
70 Chapter 3 C A P I T AL STRUC TURE MANAGEMENT
Or, Rs. 100,000 = PMT PVIFA14%, 8 (1 + 0.14)
Or, Rs. 100,000 = PMT 4.6389 1.14
PMT = = Rs 18,909.6685 18,909.67
Second prepare amortization schedule
Year PMT Interest (14%) Principal Loan balance
0 18,909.67 - 18,909.67 Rs 81,090.33
1 18,909.67 11,352.65 7,557.02 73,533.31
2 18,909.67 10,294.66 8,615.01 64,918.30
3 18,909.67 9,088.56 9,821.11 55,097.19
4 18,909.67 7,713.61 11,196.06 43,901.13
5 18,909.67 6,146.16 12,763.51 31,137.62
6 18,909.67 4,359.27 14,550.40 16,587.22
7 18,909.67 2,322.45 16,587.22 -
8 - - - -
Third calculate the after Tax Cash Flow
After tax PVIF
Year PMT Interest Depreciation Tax shield ATCF PV
SVn @8.4%
0 18,909.67 - - - - 18,909.67 1.0000 18909.67
1 18,909.67 11,352.65 20,000 12,541.06 - 6,368.61 0.9225 5875.04
2 18,909.67 10,294.66 32,000 16,917.86 - 1,991.81 0.8510 1695.03
3 18,909.67 9,088.56 19,000 11,235.42 - 7,674.25 0.7851 6025.05
4 18,909.67 7,713.61 12,000 7,885.44 - 11,024.23 0.7242 7983.75
5 18,909.67 6,146.16 11,000 6,858.46 - 12,051.21 0.6681 8051.41
6 18,909.67 4,359.27 6,000 4,143.71 - 14,765.96 0.6163 9100.26
7 18,909.67 2,322.45 - 928.98 - 17,980.69 0.5686 10223.82
8 - - - - 4,800 (4,800) 0.5245 (2517.60)
PV (P) 65,346.43
Lease financing method has the lower present value of cash outflows.
Working notes:
After tax salvage value (SVn) = Cash salvage value (1 T)
= Rs. 8,000 (1 0.40) = Rs. 4,800

Calculation of depreciation
Year 1 2 3 4 5 6
Dep. rate (%) 20% 32 19 12 11 6
Depreciation 20,000 32,000 19,000 12,000 11,000 6,000
ILLUSTRATION 4. Suppose that a machine could be either purchased for Rs 15,000 or leased
for 3 years with an operating lease. The lease payments would be Rs 6,600 per year to be
paid at the end of years 1, 2 and 3. The lease would be tax deductible. If the machine were
purchased, annual depreciation charges would be Rs 3,000 per year, and the machine's
purchase would be financed with a 3 year term loan at 9 percent requiring equal end of year
payments of Rs 5,926 each. The annual lease payments include a maintenance contract on
the machine over the lease's term. The firm estimates that, without the maintenance
contract, the annual maintenance expenses related to the machine would be Rs 600 per year.
The after-tax salvage value of the machine at the end of the third year is estimated to be Rs
6,000 if the purchase alternative is chosen. The firm is in a 50 percent tax bracket, and all
cash flows are to be discounted at the firm's cost of capital of 11 percent. Should the firm
purchase or lease the machine?
SOLUTION
Given,
Lease:
Leases period (n) = 3 years
Lease rent (payable at the end of year) = Rs 6,600
Purchase:
Cost of machine (I0) = Rs 15,000
 TERM LOAN S AND LEASE FINAN CING Chapter 3 71
Depreciation = Rs 3,000 per year
Number of years (n) = 3 years
Cost of debt (kd) = 9%
Loan installment (PMT) = Rs 5,926
Maintenance expenses = Rs 600
After-tax salvage value (SVn) = Rs 6,000
Tax rate = 50%
Cost of capital (k) = 11%
Step 1: Calculation of PV of cash outflows of leasing
Tax saving on lease After-tax lease
Year Lease rent PVIFA at 11% Present value
rent rent
1-3 Rs 6,600 Rs 3,300 Rs 3,300 2.4437 Rs 8,064.21
Step 2: Calculation of PV of cash outflows of purchasing
Preparation of loan amortization schedule
Year Installment Interest Principal Loan outstanding
0 Rs 15,000
1 Rs 5,926 Rs 1,350 Rs 4,576 10,424
2 5,926 938.16 4,987.84 5,436.16
3 5,926 489.25 5,436.75

Calculation of after-tax cash flow

Tax saving on int.
Salvage value After-tax After-tax cash
YearInstallment Interest Dep.
& Dep. (Dep. + Int.)
after-tax maintenance Cost flow*
T
1 Rs 5,926 Rs 1,350 Rs 3,000 Rs 2,175 Rs 300 Rs 4,051
2 5,926 938.16 3,000 1,969.08 300 4,256.92
3 5,926 489.25 3,000 1,744.63 6,000 300 (1,518.63)
* After-tax cash flow = Installment Tax saving on interest and depreciation + After-tax
maintenance cost After-tax salvage value
72 Chapter 3 C A P I T AL STRUC TURE MANAGEMENT
Calculation of present value of after-tax cash flow
Year After-tax cash flow PVIF at 11% Present value
1 Rs 4,051 0.9009 Rs 3,649.55
2 4,256.92 0.8116 3,454.92
3 (1,518.63) 0.7312 (1,110.42)
PV of after-tax cash flow Rs 5,994.05
Decision: Cost of purchasing alternative (Rs 5,994.05) is less than cost of leasing (Rs 8,064.21),
therefore firm should purchase the machine.
Note: In this problem it is given that all cash flows are to be discounted at firm's cost of capital of
11%. Therefore cash flows are discounted at 11%. Otherwise, after-tax cost of debt should be
used as appropriate discount rate.
ILLUSTRATION 5. The Panchakanya Steel Company (PSC) has decided to acquire a new
cutting machine. One alternative is to lease the machine on a 4-year guideline contract for a
lease payment or Rs 9,500 per year, with payments to be made at the beginning of each
year. Alternatively, PSC could purchase the machine outright for Rs 38,000, financing the
purchase by a bank loan for the net purchase price and amortizing the loan over a 4-year
period at an interest rate of 10 percent per year. The machine falls into the MACRS 3-year
class. It has a residual value of Rs 9,000, which is the expected market value after 4 years,
when PSC plans to replace the machine irrespective of whether it leases or buys. PSC has a
marginal tax rate of 40 percent.
a. What is PSCs PV of cost of leasing?
b. What is PSCs PV of cost of purchasing?
c. Should the machine be leased or purchased?
d. The appropriate discount rate for cash flows used in the analysis is the firms after-tax
cost of debt. Why?
e. The residual value is the least certain cash flow in the analysis. How might PSC
incorporate differential riskiness of this cash flow into the analysis?
SOLUTION
Given,
Lease alternative:
Number of period (n) = 4 years
Lease payment (Lt) = Rs 9,500 payable in advance
Borrow purchase alternative:
Purchase price (I0) = Rs 38,000
Number of periods (n) = 4 years
Interest rate (kd) = 10%
Residual (salvage) value = Rs 9,000
Depreciation = MACRS 3-year class
Tax rate = 40%
(a) Calculation of PV of cost of leasing i.e. PV (L) = ?
We have,
PV (L) = Lt + Lt (1 T) PVIFAkdt, n1 Lt (T) PVIFkdt, n
= Rs 9,500 + Rs 9,500 (1 0.40) PVIFA6, 41 Rs 9,500 (0.40) PVIF6,, 4
= Rs 9,500 + Rs 5,700 2.6730 Rs 3,800 0.7921
= Rs 24,736.10 Rs 3,009.98 = Rs 21,726.12
Therefore, the present value of leasing is Rs 21,726.12.
b) Calculation of PV of purchasing i.e. PV(P) = ?
(i) Assuming the interest payable in advance
First calculate the PMT
We have,
PVA = PMT PVIFAkd,n (1 + kd)
or, Rs 38,000 = PMT PVIFA10,4 (1 + 0.10)
or, Rs 38,000 = PMT 3.1699 1.10
PMT = = Rs 10,897.93
Second prepare amortization schedule
Year Payment Interest Principal Loan balance
 TERM LOAN S AND LEASE FINAN CING Chapter 3 73
0 10,897.93 Rs 10,897.93 Rs 27,102.07
1 10,897.93 2,710.21 8,187.72 18,914.35
2 10,897.93 1,891.44 9,006.49 9,907.86
3 10,897.93 990.79 9,907.14 0
4

Third calculate the after-tax cash flows

After- After-tax cash
Year Payment Interest Dep. Tax save
tax SV flow
0 Rs 10,897.93 Rs 10,897.93
1 10,897.93 2,710.21 12,665.4 6,150.24 4,747.69
2 10,897.93 1,891.44 16,891 7,512.98 3,384.95
3 10,897.93 990.79 5,627.8 2,647.44 8,250.49
4 2,815.8 1,126.32 5,400 (6,526.32)

Working notes:
Calculation of depreciation
Year 1 2 3 4
Depreciation rate 33.33% 44.45% 14.81% 7.41%
Dep. = Dep. Rate Purchase price Rs 12,665.4 Rs 16,891 Rs 5,627.8 Rs 2,815.8

Fourth calculate the PV of after-tax cash flows

Year After-tax cash flow PVIF@ 6% PV
0 Rs 10,897.93 1 Rs 10,897.93
1 4,747.69 0.9434 4,478.97
2 3,384.95 0.8900 3,012.61
3 8,250.49 0.8396 6,927.11
4 (6,526.32) 0.7921 (5,169.50)
PV (P) Rs 20,147.12
Therefore, the present value of the purchasing is Rs 20,147.12.
(ii) Assuming the interest payable in end of the period
First calculate the PMT
We have,
PVA = PMT PVIFAkd,n
or, Rs 38,000 = PMT PVIFA10,4
or, Rs 38,000 = PMT 3.1699
PMT = = Rs 11,987.76
Second prepare amortization schedule
Year Payment Interest Principal Loan balance
0 Rs 38,000
1 Rs 11,987.76 Rs 3,800 Rs 8,187.76 29,812.24
2 11,987.76 2,981.22 9006.54 20,805.70
3 11,987.76 2,080.57 9907.19 10,898.51
4 11,987.76 1,089.85 10,897.91
74 Chapter 3 C A P I T AL STRUC TURE MANAGEMENT
Third calculate the after-tax cash flows
After- After-tax cash
Year Payment Interest Depreciation Tax save
tax SV flow
1 Rs 11,987.76 Rs 3,800 Rs 12,665.4 Rs 6,586.16 Rs 5,401.6
2 11,987.76 2,981.22 16,891 7,948.89 4,038.87
3 11,987.76 2,080.57 5,627.8 3,083.35 8,904.41
4 11,987.76 1,089.85 2,815.8 1,562.26 Rs 5,400 5,025.5

Fourth calculate the PV of after-tax cash flows

Year After-tax cash flow PVIF@ 6% PV
1 Rs 5,401.6 0.9434 Rs 5,095.87
2 4,038.87 0.8900 3,594.59
3 8,904.41 0.8396 7,476.14
4 5,025.5 0.7921 3,980.70
PV (P) 20,147.30
Therefore, the present value of the purchasing is Rs 20,147.30
c. Because the present value of the purchase is less than the present value of leasing, the
borrow purchase is preferred. Borrow purchase rather than leasing the cutting machine should
result in an incremental savings of Rs 1,579 (Rs 21,726.12 Rs 20,147.12)
d. Use the cost of debt because most cash flows are fixed by contract and consequently are
relatively certain; thus lease cash flows have about the same risk as the firms debt. Also,
leasing is considered as a substitute for debt. Use an after-tax cost rate to account for interest
tax deductibility.
e. The firm could increase the discount rate on the residual value cash flow. Note that since the
firm plans to replace the machine after 4 years, the residual value is treated as an inflow in
the cost of owning analysis. This makes it reasonable to raise the discount rate for analysis
purposes. However, had the firm planned to continue using the machine, then we would have
had to place the estimated residual value as an additional year-4 outflow in the leasing, but
without a tax adjustment. Then, higher risk would have been reflected in a lower discount
rate.
ILLUSTRATION 6. a. The CL Company (CLCO) produces industrial machines, which have
five- year lives. CLCO is willing to either sell the machines for Rs 60,000 or to lease them at a
rental that, because of competitive factors, yields an after-tax return to CLCO of 9 percent
its cost of capital. What is the Company's competitive lease-rental rate? (Assume straight-line
depreciation, zero salvage value, and an effective corporate tax rate of 40 percent.)
b. The ST Company (STCO) is contemplating the purchase of a machine exactly like those
rented by CLCO. The machine will produce net benefits of Rs 20,000 per year. STCO can
buy the machine for Rs 60,000 or rent it from CLCO at the competitive lease-rental rate.
STCO's cost of capital is 16 percent, its cost of debt 15 percent, and tax rate = 40
percent. Which alternative is better for STCO? Note that the discount rate applied by the
company is its after-tax cost of debt.
c. If CLCO's cost of capital is 12 percent and competition exists among lessors, solve for
the new equilibrium rental rate. Will STCO's decision be altered?
SOLUTION
Given,
Life of machine (n) = 5 years
Cost of machine (I0) = Rs 60,000
Cost of capital (k) = 9%
Depreciation = Straight line
Salvage value (SVn) =0
Tax rate (T) = 40%
Lease rental rate (Lt) =?
a. We have,
NPVLOR = I0 +[ITC + Dep. T PVIFA k, n + SVn PVIF k,n] + Lt (1 T) PVIFA k, n
Competitive Lt is that lease rent at which net present value of lessor (NPV LOR) equals to zero.
So, 0 = 60,000 + [Rs 0 + Rs 12,000 (0.40) PVIFA 9,5 + Rs 0] + Lt(1 0.40) PVIFA9,5
 TERM LOAN S AND LEASE FINAN CING Chapter 3 75
or, 0 = 60,000 + [Rs 0 + Rs 4,800 3.8897 + Rs 0] + Lt 0.6 3.8897
or, 60,000 = 18,670.56 + Lt 2.3338
Lt = = Rs 17,709.08
b. Lease versus purchase decision
Calculation of PV of cash outflows of leasing
We have,
PV (L) = Lt (1 T) PVIFA kdt, n
= Rs 17,709.08 (1 0.40) PVIFA 9, 5
= Rs 10,625.45 3.8897
= Rs 41,329.80
Calculation of PV of cash outflows of purchasing
PV (P) = Cost of asset PV of ownership benefit
= I0 [ITC + Depreciation (T) PVIFA kdt, n + SVn PVIF kdt , n ]
= Rs 60,000 Rs 0 Rs 12,000 (0.40) PVIFA 9, 5 Rs 0
= Rs 60,000 Rs 0 Rs 4,800 3.8897 Rs 0
= Rs 60,000 Rs 4,800 3.8897
= Rs 41,329.44
Decision:
Present value of leasing equal with present value of purchasing. So, if cost is considered
lessee will be indifferent between two alternatives.
Note: Annual benefit that is produced by the machine is available in both alternatives so it can be
taken as irrelevant factor for leasing versus owning decision.
c. New equilibrium rental rate (Lt) = ?
We have,
NPVLOR = I0 +[ITC + Dep. T PVIFA k, n + SVn PVIF k,n] + Lt (1 T) PVIFA k, n
Competitive Lt is that lease rent at which net present value of lessor (NPV LOR) equals to zero.
So, 0 = 60,000 + [Rs 0 + Rs 12,000 (0.40) PVIFA 12,5 + Rs 0] + Lt(1 0.40)
PVIFA12,5
or, 0 = 60,000 + [Rs 0 + Rs 4,800 3.6048 + Rs 0] + Lt 0.6 3.6048
or, 60,000 = 17,303.04 + Lt 2.16288
Lt = = Rs 19,740.79
Lease versus purchase analysis
Calculation of PV of cash outflows of leasing
PV (L) = Lt (1 T) PVIFA kdT,n
= Rs 19,740.79 (1 0.40) PVIFA 9, 5
= Rs 11,844.47 3.8897
= Rs 46,071.45
Calculation of PV of cash outflows of purchasing
PV (P) = Rs 41,329.44
Note: The present value of purchasing is not changed.
Decision:
Stockton's decision will be altered. The present value of the cost of leasing is higher than the
present value of buying. So, the buying alternative is preferable.
ILLUSTRATION 7. Public Feed Industry wishes to acquire a merchandised feed spreader that
costs
Rs 80,000. The Feed Company intends to operate the equipment for 5 years, at which time it
will need to be replaced. However, it is expected to have a salvage value of Rs 10,000 at the
end of the fifth year. The asset will be depreciated on a straight-line basis (Rs 16,000 per
year) over the 5 year, and Public Feed is in a 30 percent tax bracket. Annual lease payment is
Rs 19,000 payable in advance. Two means for financing the feed spreader are available. A
debt alternative carries an interest cost of 10 percent. Debt payments will be at the start of
each of the 5 years using mortgage type of debt amortization.
Using the present value method, determine the best alternative.

SOLUTION
Given,
76 Chapter 3 C A P I T AL STRUC TURE MANAGEMENT
Purchase price of machine (I0) = Rs 80,000
Useful life of press (n) = 5 years
Salvage value (SVn) = Rs 10,000
Annual depreciation per year (straight line) = Rs 16,000
Annual lease payment (Lt) = Rs 19,000
Interest rate or before tax cost of debt (kd) = 10%
Tax rate (T) = 30%
Analysis of lease versus purchase by PV of after-tax cash flow method
Alternative 1: Lease alternative
(1) (2) (3) (4) (5)
End of Lease Tax shield (1) Cash outflows after- PVIF at Present value of
year payment (0.30) taxes (1) (2) 7% cash outflows
0 Rs 19,000 Rs 19,000 1.0000 Rs 19,000
14 Rs 19,000 Rs 5,700 13,300 3.3872 45,050
5 Rs 5,700 (5,700) 0.7130 (4,064)
PV of cash outflows Rs 59,986
Purchasing Alternative:
First calculate the loan installment
We have,
PVADUE = PMT (1 + kd)
or, Rs 80,000 = PMT (1 + 0.10)
or, Rs 80,000 = PMT 3.7908 1.10
or, PMT = = Rs 19,185
Second calculate the debt payment schedule or amortization schedule
Year Installments Interest Principal paid Balance
0 19,185 Rs 19,185 Rs 60,815
1 19,185 6,082 13,103 47,712
2 19,185 4,771 14,414 33,298
3 19,185 3,330 15,855 17,443
4 19,185 1,742 17,443
Third calculate the present value of purchasing
Tax PV
Year Installment Interest Dep. SVn CFAT PV at 7%
shield factor
0 19,185 19,185 1 19,185
1 19,185 Rs 6,082 16,000 6,625 12,560 0.9346 11,738
2 19,185 4,771 16,000 6,231 12,954 0.8734 11,314
3 19,185 3,330 16,000 5,799 13,386 0.8163 10,927
4 19,185 1,742 16,000 5,323 13,862 0.7629 10,575
5 16,000 4,800 7,000 (11,800) 0.7130 (8,413)
PV of after-tax cash outflow under purchasing 55,326
After-tax cash salvage value = CSV Tax
= Rs 10,000 30% of Rs 10,000 = Rs 7,000
Tabulation of result:
Method Present value of cost
Leasing Rs 59,986
Purchasing Rs 55,326
As the present value of cash outflows for the purchase alternative (Rs 55,326) is lower than
that of leasing
(Rs 59,986), company should purchase the asset.
 TERM LOAN S AND LEASE FINAN CING Chapter 3 77

Problems
PROBLEM 1. Yak and Yeti Company wishes to evaluate two plans, leasing and
Lease versus Purchase borrowing to purchase, for financing an oven.
Decision Leasing: The Company could lease the oven under a five-year lease
requiring annual end-of-year payments of Rs 5,000.
Purchasing: The oven costs Rs 20,000 and will have a five-year life. The
asset will be depreciated under straight line method by 20 percent for
each of the five years. The total purchase price will be financed by a five-
year, 15 percent loan requiring annual end-of-year payments of Rs 5,967.
The firm is in the 40 percent tax bracket.
a. What is the cost of leasing?
b. What is the cost of owning?
c. Should the firm lease or purchase the oven?
PROBLEM 2. The Nirmal Company is faced with the decision of whether it should
Lease versus Purchase purchase or lease a new forklift truck. The truck can be leased on five
Decision
year contract for Rs 6,000 a year or it can be purchased for Rs 25,000.
The salvage value of the truck after five years is Rs 2,000. The company
uses straight-line depreciation. The discount rate applied is its after-tax
cost of debt. The company can borrow at 15 percent and has a 40 percent
marginal tax rate and a 12 percent cost of capital.
a. Calculate the cost of leasing.
b. Calculate the cost of purchasing.
c. Should the firm lease or purchase the truck?
PROBLEM 3. A manufacturing company wishes to acquire three heavy trucks that cost
Lease versus Purchase Rs 100,000 in total. A leasing company has offered to lease the trucks to
Decision a manufacturing company for a total Rs 25,000 per year for each of the
five years with lease payment payable in advance. To evaluate this
option, manufacturing company depreciated the trucks via straight-line
depreciation over their five-year normal recovery period and 8 percent
investment tax credit is in effect. The marginal tax rate applicable is 40
percent and before tax cost of debt is 11.67%. If the trucks are leased,
the ITC will be passed on to the leasing company. Should the
manufacturing company lease of purchase the trucks?
PROBLEM 4. A certain machine could be either purchased for Rs 15,000 or leased for 3
Lease versus Purchase years. The lease payments would be Rs 6,600 per year to be paid at the
Decision
end of years, 1, 2, and 3. If the machine were purchased, annual
depreciation charges would be Rs 3,000, and the machine would be
financed with a 3-year term loan at 9 percent requiring equal end of year
payments of Rs 5,926 each. The annual lease payments include a
maintenance contract on the machine over the lease's term. The firm
estimates that, without the maintenance contract, the annual
maintenance expense related to the machine would be Rs 600 per year.
The after-tax salvage value of the machine at the end of the third year is
estimated to be Rs 6,000 if the purchase alternative is chosen. The firm is
in a 50 percent tax bracket and its before tax cost of debt is 9 percent.
Should the firm purchase or lease the machine?
PROBLEM 5. C.P. Company wishes to acquire a Rs 100,000 press, which has a useful
Lease versus Purchase life of 8 years. At the end of this time, its scrap value will be Rs 20,000.
Decision
78 Chapter 3 C A P I T AL STRUC TURE MANAGEMENT
The asset falls into the 5- year property class for cost recovery
(depreciation) purposes. The company can use either lease or debt
financing. Lease payments of Rs 14,000 at the beginning of each of the 8
years would be required. If debt financed, the interest rate would be 10
percent and debt payments would be due at the beginning of each of the
8 years. (Interest would be amortized as a mortgage type of debt
instrument.) The company is in a 15 percent tax bracket. Which method
of financing has the lowest present value of cash outflows?

PROBLEM 6. Tribhuvan University needs a generator. It can either buy it for Rs 250,000
Lease versus Purchase or lease it from the company. The lease and purchase terms are as
Decision
follows:
Leasing: TU lease under a five-year lease requiring annual end-of-year
payments of
Rs 62,000.
Purchasing: The generator costs Rs 250,000 and will have a five-year
life. The salvage value of generator is Rs 10,000. The investment tax
credit is 10 percent. The annual maintenance expenses are Rs 1,000 per
year (which has been included in lease rent under leasing alternative).
The asset will be depreciated under straight line method for five years.
The interest rate on bank loan is 10 percent. The firm is in the 40 percent
tax bracket.
a. What is the cost of leasing?
b. What is the cost of owning?
c. Should the firm lease or purchase the generator?
PROBLEM 7. The Nepal Transportation Company (NTC) has decided to acquire a new
Lease versus Purchase truck. One alternative is to lease the truck on a 4-year guideline contract
Decision
for a lease payment of Rs 10,000 per year, with payments to be made at
the beginning of each year. The lease would include maintenance.
Alternatively, NTC could purchase the truck outright for Rs 40,000,
financing the purchase by a bank loan for the net purchase price and
amortizing the loan over a 4-year period at an interest rate of 10 percent
per year. Under the borrow to purchase arrangement, NTC would have to
maintain the truck at a cost of Rs 1,000 per year, payable at year end.
The truck falls into the MCRCS 3-year class. It has a residual value of Rs
10,000, which is the expected market value after 4 years, when NTC
plans to replace the truck irrespective of whether it leases or buys. NTC
has a marginal rate of 40 percent.
a. What is the NTCs PV cost of leasing?
b. What is the NTCs PV cost of owing?
c. Should the truck be leased or purchased?
d. The appropriate discount rate for cash flows used in the analysis is
the firms after-tax cost of debt. Why?
 TERM LOAN S AND LEASE FINAN CING Chapter 3 79

PROBLEM 8. Sunkoshi Mining Company must install Rs 1.5 million of new machinery in
Lease versus Purchase its Lamosanghu mine. It can obtain a bank loan for 100 percent of the
Decision purchase price, or it can lease the machinery. Assume that the following
facts apply.
1. The machinery, which has a useful life of 4 years, falls into the
MACRS 3- year class.
2. Estimated maintenance expenses are Rs 75,000 per year, payable at
the beginning of each year.
3. The firm's tax rate is 40 percent.
4. The loan would have an interest rate of 15 percent.
5. The lease terms call for Rs 400,000 payments at the end of each of
the next 4 years.
6. Under either the lease or the purchase, the company must pay for
insurance, property taxes, and maintenance.
7. The estimated residual (and salvage) value is Rs 250,000.
What is the NAL of the lease?
PROBLEM 9. A Janakpur Industries must install Rs 1 million of new machinery in its
Lease versus Purchase Jaleshwor plant. It can obtain a bank loan for 100 percent of the required
Decision
amount. Alternatively, a Jaleshwor investment banking firm which
represents a group of investors believes that it can arrange for a lease
financing plan. Assume that these facts apply.
1. The equipment falls in the MACRS 3-year class.
2. Estimated maintenance expenses are Rs 50,000 per year.
3. The firm's tax rate is 34 percent.
4. If the money is borrowed, the bank loan will be at a rate of 14
percent, amortized in 3 equal installments at the end of each year.
5. The tentative lease terms call for payments of Rs 320,000 at the end
of each year for 3 years. The lease is a guideline lease.
6. Under the proposed lease terms. The lessee must pay for insurance,
property taxes, and maintenance.
7. Janakpur must use the equipment if it is to continue in business, so it
will almost certainly want to acquire the property at the end of the
lease. If it does, then under the lease terms it can purchase the
machinery at its fair market value at that time. The best estimate of
this market value is Rs 200,000, but it could be much higher or lower
under certain circumstances.
To assist management in making the proper lease-versus-buy decision,
you are asked to answer the following questions:
Assuming that the lease can be arranged, should the firm lease or borrow
and buy the equipment? Explain. (Hint: In this situation, the firm
plans to use the assets beyond the term of the lease. Thus, the
residual value becomes a cost to leasing in Year 3. Also, there is no
Year 3 residual value tax consequence, as the firm cannot
immediately deduct the Year 3 purchase price from taxable income)

Integrative Problem
Lumbini Securities Inc. has decided to acquire a new market data and quotation
system for its Lalitpur home office. The system receives current market prices
80 Chapter 3 C A P I T AL STRUC TURE MANAGEMENT
and other information from several on-line data services, then either displays
the information on a screen or stores it for later retrieval by the firms brokers.
The system also permits customers to call up current quotes on terminals in the
lobby. The equipment costs Rs 1,000,000, and, if it were purchased, Lumbini
could obtain a term loan for the full purchase price at a 10 percent interest
rate. The equipment is classified as a special-purpose computer, so it falls into
the MACRS 3-year class. If the system were purchased, a 4-year maintenance
contract could be obtained at a cost of Rs 20,000 per year, payable at the
beginning of each year. The equipment would be sold after 4 years, and the
best estimate of its residual value at that time is Rs 100,000. However, since
real-time display system technology is changing rapidly, the actual residual
value is uncertain. As an alternative to the borrow-and-buy plan, the equipment
manufacturer informed Lumbini that consolidated leasing would be willing to
write a 4-year guideline lease on the equipment, including maintenance, for
payments of Rs 280,000 at the beginning of each year. Lumbinis tax rate is 40
percent. You have been asked to analyze the lease-versus-purchase decision,
and in the process to answer the following questions:
1. Who are the two parties to a lease transaction?
2. What are the types of leases, and what are their characteristics?
3. How are leases classified for tax purposes?
4. What effect does leasing have on a firms balance sheet?
5. What effect does leasing have on a firms capital structure?
6. What is the present value cost of owning the equipment?
7. Explain the rationale for the discount rate you used to find the present
value.
8. What is Lumbinis present value cost of leasing the equipment?
9. What is the net advantage to leasing (NAL)? Does your analysis indicate
that Lumbini should buy or lease the equipment? Explain.
10. Now assume that the equipments residual value could be as low as Rs 0 or
as high as Rs 200,000, but that Rs 100,000 is the expected value. Since
the residual value is riskier than the other cash flows in the analysis, this
differential risk should be incorporated into the analysis. Describe how this
could be accomplished. (No calculations are necessary, but explain how
you would modify the analysis if calculations were required.) What effect
would increased uncertainty about the residual value have on Lumbinis
lease-versus-purchase decision?
11. The lessee compares the cost of owning the equipment with the cost of
leasing it. Now put yourself in the lessors shoes. In a few sentences, how
should you analyze the decision to write or not write the lease?
12. Assume that the lease payments were actually Rs 300,000 per year, that
consolidated leasing is also in the 40 percent tax bracket, and that it also
forecasts a Rs 100,000 residual value. Also, to furnish the maintenance
support, consolidated would have to purchase a maintenance contract
from the manufacturer at the same Rs 20,000 annual cost, again paid in
advance. Consolidated leasing can obtain an expected 10 percent pre-tax
return on investments of similar risk. What would consolidateds NPV and
IRR of leasing be under these conditions?
13. What do you think the lessors NPV would be if the lease payment were set
at
Rs 280,000 per year?
14. Lumbinis management has been considering moving to a new downtown
location, and they are concerned that these plans may come to fruition
 TERM LOAN S AND LEASE FINAN CING Chapter 3 81
prior to the expiration of the lease. If the move occurs, Lumbini would buy
or lease an entirely new set of equipment, and hence management would
like to include a cancellation clause in the lease contract. What impact
would such a clause have on the riskiness of the lease from Lumbinis
standpoint? From the lessors standpoint? If you were the lessor, would you
insist on changing any of the lease terms if a cancellation clause were
added? Should the cancellation clause contain any restrictive covenants
and/or penalties of the type contained in bond indentures or provisions
similar to call premiums?

1. a. Rs 11,669.10
b. Rs 13,776.48
c. Lease the oven
2. a. Rs 14,002.92
b. Rs 16,543.13
3. PV (L) = Rs 68,678,
PV (P) = Rs 59,198.40
4. PV (L) = Rs 9,071.70,
PV (P) = Rs 6,443.43
5. PV of leasing = Rs 73,816.68;
PV of purchasing = Rs 79,125.0685
6. a. Rs 156,701.28
b. Rs 139,176.36
7. a. Rs 22,869.60
b. Rs 23,036.81
82 Chapter 3 C A P I T AL STRUC TURE MANAGEMENT