Chapter - 14

LEASING DECISION

Learning Outcomes

After going through the chapter student shall be able to understand

❑ Meaning of Leasing Decision
❑ Evaluation of Lease financing and Bank Financing
❑ Evaluation of Lease financing from Lessor and Lessee point of view.
❑ Break Even Lease rental for Lessor and for Lessee
❑ Replacement of Machine with Bank and Lease financing

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 Page 14.2 STRATEGIC FINANCIAL MANAGEMENT

EVALUATION FOR LESSEE (BANK VS LEASE)

Question No. - 1A [Study Mat.]
XYZ co is planning to install a machine which becomes scrap in 3 years. It requires an investment of 180 lakhs
and scrap realizes 18 lakhs. The company has following options:
(1) to take a loan @ 18% and buy that machine, or
(2) take it on lease @ 444/000 payable annually for 3 years.
Depreciation is 40% (WDV). Tax rate is 35%. Determine which option is better.
Ans: Loan option = 120.63 Lakh; Lease option = 125.416

Question No. - 1B [Nov-2011-8M] [May-2004-old-20M] [SM-OLD]

Your company 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 (’000) 500 850 850
Interest (’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
[CMA- Study Mat.] [CMA-Dec-2018-8M] [CMA-PTP-June-2014-12M] [CMA-MTP-Dec-2019-8M]
Ans: PV of outflow under purchase = 8,90,470;
PV of outflow under Lease = 12,02,925

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 LEASING DECISION Page 14.3
Question No. - 1C [May-2006-15M] [RTP-Nov-2012] [Study Mat.] [MTP-May-2019-8M]
ABC Company has decided to acquire a 5,00,000 pulp control device that has a useful life of ten years. A
subsidy of 50,000 is available at the time the device is acquired and placed into service. The device would be
depreciated on straight-line basis and no salvage value is expected. The company is in the 50% tax bracket. If the
acquisition is financed with a lease, lease payments of 55,000 would be required at the beginning of each year.
The company can also borrow at 10% repayable in equal installments. Debt payments would be due at the
beginning of each year:
(i) What is the present value of cash outflow for each of these financing alternatives , using the after-tax
cost of debt?
(ii) Which of the two alternatives is preferable?
Ans: (i) PV of cash outflow under lease = 2,33,585, PV of outflow under Loan = 2,56,997.

Question No. - 1D [May-2015-8M]

R Ltd. requires a machine for 5 years. There are two alternatives either to take it on lease or buy. The company is
reluctant to invest initial amount for the project and approaches their bankers. Bankers are ready to finance 100%
of its initial required amount at 15% rate of interest for any of the alternatives.
Under lease option, upfront Security deposit of Rs. 5,00,000/- is payable to lessor which is equal to cost of
machine. Out of which, 40% shall be adjusted equally against annual lease rent. At the end of life of the machine,
expected scrap value will be at book value after providing depreciation @ 20% on written down value basis.
Under buying option, loan repayment is in equal annual installments of principal amount, which is equal to annual
lease rent charges. However, in case of bank finance for lease option, repayment of principal amount equal to
lease rent is adjusted every year, and the balance at the end of 5th year.
Assume Income tax rate is 30%, interest is payable at the end of every year and discount rate is @ 15% p.a. The
following discounting factors are given:
Year 1 2 3 4 5
Factor 0.8696 0.7562 0.6576 0.5718 0.4972
Which option would you suggest on the basis of net present values?

Question No. - 1E
ABC Limited has decided to go in for a new model of Mercedes Car. The cost of the vehicle is 40 lakhs. The
company has two alternatives:
(i) taking the car on finance lease, or
(ii) borrowing and purchasing the car.
BMN Limited is willing to provide the car on finance lease to ABC Limited for five years at an annual rental of 
8.75 lakhs, payable at the end of the year.
The vehicle is expected to have useful life of 5 years, and it will fetch a net salvage value of 10 lakhs at the end of
year five. The depreciation rate for tax purpose is 40% on written- down value basis. The applicable tax rate for
the company is 35%. The applicable before tax borrowing rate for the company is 13.8462%.
What is the net advantage of leasing for ABC Limited?
The present value interest factor at different rates of discount are as under:
Rate of Discount Y-1 Y-2 Y-3 Y-4 Y-5
0.138462 0.8784 0.7715 0.6777 0.5953 0.5229
0.09 0.9174 0.8417 0.7722 0.7084 0.6499
[CMA-PTP-June-2014-7M] [CMA-RTP-Dec-2014]

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 Page 14.4 STRATEGIC FINANCIAL MANAGEMENT
Question No. - 1F [MTP-May-2014-10M] [RTP-Nov-2014]
AGD Co is a profitable company which is considering the purchase of a machine costing  32,00,000. If
purchased, AGD Co would incur annual maintenance costs of  2,50,000. The machine would be used for three
years and at the end of this period would be sold for 5,00,000. Alternatively, the machine could be obtained
under an operating lease for an annual lease rental of  12,00,000 per year, payable in advance. AGD Co can
claim depreciation @ 25% on WDV basis. Annual lease rental will be paid in the beginning of each year.
The company pays tax on profits at an annual rate of 30% and all tax liabilities are paid one year in arrears.
Required:
(1) Using an after-tax borrowing rate of 7%, evaluate whether AGD Co should purchase or lease the new
machine.
(2) Suppose a bank had offered to lend AGD Co  32,00,000 for a period of five years interest payable every six
months, then you are required to:
(i) Calculate the Annual Percentage Rate (APR) implied by the bank’s offer with interest payable every six
months.
(ii) Calculate the amount of installment payable at the end of each six-month period if the offered loan is to be
repaid in equal installments.

 TEST YOUR KNOWLEDGE

’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’
Question No. – 1.1
Lee Industries wishes to install a plant in its factory at a cost of  100 lacs. It can lease the plant from LOR Co. for
3 year end payments of 34 lacs. LOR will maintain the plant at  5 lacs per annum payable at the end of each year
with no charge to Lee for maintenance. Alternatively, Lee could borrow  100 lacs from the bank, either take an
upfront extended warranty for 3 years for an additional 10 lacs, or incur 5 lacs maintenance charges like LOR
without this extended warranty. Bank loan would involve an initial payment of  1 lac and three year end equated
payments of principal together with 14% interest. The plant will qualify for annual depreciation of 31 lacs and 7
lacs is the expected salvage value. Both LOR and Lee have an after tax weighted average cost of capital of 10%
and a tax rate of 50%.
Find out if the extended warranty is worthwhile.
Compute the Net Advantage to Leasing for Lee under the better option chosen for maintenance. Assume that
extended warranty costs qualify for tax deduction at the end of year 1.
While evaluating this proposal for LOR, which discount rate would you use to determine the present value of the
cash flows? Why?
(Show calculations in  lacs up to 2 decimal places and use p.v. factors up to 3 decimal places. Present your cash
flows for each year.)
[CMA-Dec-2017-8M]

Question No. - 1.2 [RTP-Nov-2013] [MTP-II-May-2019-8M]

Sundaram Ltd. discounts its cash flows at 16% and is in the tax bracket of 35%. For the acquisition of a machinery
worth 1000000, it has two options- either acquire the asset by taking a bank loan @ 15% p.a. repayable in 5 yearly
installments of 200000 each plus interest or to lease the asset at yearly rentals of 334000 for five (5) years, in
both cases the instalment is payable at the end of the year. Depreciation is to be applied at the rate of 15% using
written down value (WDV) method. You are required to advise which of the financing options is to be exercised
and why.
Year 1 2 3 4 5
P.V factor @ 6% 0.862 0.743 0.641 0.552 0.476

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 LEASING DECISION Page 14.5

Question No. – 1.3

H L Manufacturing Ltd. desires to acquire a diesel generating machine set costing  40 lakh which has an economic
life of 10 years at the end of which the asset is not expected to have any residual value. The company is considering
two alternatives:
(a) taking the machine on lease
(b) purchasing the asset outright by raising a loan.
Lease payments are equal annual amounts and have to be made in advance and the lessor requires the asset to be
completely amortized over its useful period.
The loan carries an interest 16% p.a. The loan has to be paid in 10 equal annual installment becoming due at the
beginning of the first year. Average rate of income tax is 50%. It is expected that the operating costs would remain
the same under either method. The company allows straight line method of depreciation and the same is accepted
for tax purposes.
Assume tax benefits at the end of the respective years and for end of year zero, tax benefit may be considered at the
end of the first year. Use 8% discount rate for p.v. factors. Present a statement showing discounted values of annual
cash flows to the nearest rupee under alternative (b), only for end of years 0 to 2 and year 10. What
should be the maximum annual lease rental for which the lease option may be preferred if you are given that the
present value under the loan option is  26,57,029?
The present value of an annuity of one Rupee.
Year 8%
1 to 9 6.247
1 to 10 6.71

Present value of Rupee one at 8%

Year 0 1 2 3 4 5 6 7 8 9 10
PV 1.00 0.926 0.857 0.794 0.735 0.681 0.630 0.583 0.540 0.500 0.463

[CMA-June-2017-8M]

Question No. – 1.4 [May-2019-Old-8M]

M/s Shanti Lal Ltd. is in the business of manufacturing products. Company decided to install a Machine under
considering buying (or) leasing option. The machine is subjected to Straight-Line method of depreciation. M/s
Shanti Lal Ltd. can raise a debt at 16% payable in 4 Equal Annual Installments of 1,68,589 each, at the beginning
of the year. In case of leasing, the Company would require to pay an annual Rent at the end of the year @ 30% of
Cost of Machine for 4 years. The company is in 45% Tax bracket. The salvage value is estimated at  12,412 at the
end of the 4 years.
Advise which of the Financing options Shanti Lal Ltd. should exercise and why ?
n 1 2 3 4
PVIF (8.8, n) 0.919 0.845 0.776 0.714
PVIF (16, n) 0.862 0.743 0.640 0.552
Ans: Bank Financing: 3,42,530; Lease Financing: 2,93,726

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 Page 14.6 STRATEGIC FINANCIAL MANAGEMENT
Question No. - 1.5 [May-2017-Old-8M]
SD Ltd. wants to purchase a machine worth 25,00,000. It has two options:
Either (i) to acquire the Asset by taking a Bank Loan @ 12% p.a. repayable in 5 yearly instalments of  5,00,000
each plus interest or,
(ii) to lease the Asset at yearly rental of  7,00,000 for five years.
In both the cases, the instalment is payable at the end of the year.
The Company discounts its Cash Flows @ 14% (after tax).
Depreciation is to be taken at 20% on Written Down Value method (WDV). The Company's tax rate is 34%.
You are required to advise which of the financing options is to be exercised and reason thereof.
Year 1 2 3 4 5
Present Value Factor (PVF) @ 14% 0.877 0.769 0.675 0.592 0.519 (Total 3.432)
Show Amount to the nearest Rupee.

Question No. - 1.6 [Nov-2015-Old-8M]

The Finance manager of ABC Corporation is analyzing firms policy regarding computers which are now being
leased on yearly basis on rental amounting to 1,00,000 per year. The computers can be bought for  5,00,000.
The purchase would be financed by 16% and the loan is repayable in 4 equal annual installments.
On account of rapid technological progress in the computer industry, it is suggested that a 4-year economic life
should be used instead of a 10-year physical life. It is estimated that the computers would be sold for  2,00,000 at
the end of 4 years.
The company uses the straight line method of depreciation. Corporate tax rate is 35%.
(i) Whether the equipment be bought or be taken on lease?
(ii) Analyze the financial viability from the point of view of the lessor, assuming 14% cost of capital.
(iii) Determine the minimum lease rent at which lessor would break even
Ans: PV of Buying option: 2,82,848; PV of lease option: 2,04,230

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 LEASING DECISION Page 14.7

EVALUATION FOR LESSOR (LEASING CO.)

Question No. - 2A
KJ Hospital wants to install a testing equipment. It wants to analyse whether to purchase the machine from a bank
borrowing or to lease it from LR. The following information is given:
(i) Cost of the equipment 50 lacs to be paid at the beginning of the 1st year
(ii) Life 5 years
(iii) Residual value 5lacs attheendofthe5thyear
(iv) Depreciation Cost less residual value, written off equally p.a. for the life of the
asset

(v) Annual Lease Rent  12 lacs Payable at the end of each year from year 1 to year 5
(vi) If asset is purchased, bank 10% Year-end payment includes 10 lacs each year
loan available at interest per towards principal and additionally, interest on the
annum balance outstanding at the beginning of the year.
(vii) Annual maintenance charges  2 lacs per payable at the end of each year
to be incurred by KJ if the annum
equipment is purchased
(viii) Tax rate applicable for KJ and 40% Assume KJ and LR are profitable
LR
(ix) After-tax weighted average 12% p.a. For both LR and KJ
cost of capital
(x) Long term capital gains tax 20% LR (For sale value in excess of the residual value)

The lessor LR is an investor company that specializes in the leasing of various medical equipments across the
country. LR would buy the equipment from its own funds, maintain the machine incurring  1 lac p.a. (year end).
LR is confident of reworking the equipment at the end of 5 years at no extra cost and finding a rural hospital which
would pay  13 lacs for it at the end of the 5th year. However, for its depreciation, it would write off equal amounts
each year considering (i) to (iv) as for KJ. The lessor is also a profit-making company with a 40% corporate tax rate
and 20% tax rate on long term capital gains.
(a) For KJ, present statements of discounted cash flows under the options of buying the machine with borrowed
funds and leasing, using the appropriate discount rate. Present year wise annual cash flows (in  lacs, up to
two decimal places), without netting off, arrive at the sub totals of pre-discounted cash flows for each year and
then apply PV factors (up to three decimals as given) and then arrive at the total present value Use ‘+’ for
inflows and ‘- or ( )’ for outflows.
(b) Evaluate the viability of the proposal for the lessor LR. Comment on the situation.
[CMA-June-2019-16M]

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 TEST YOUR KNOWLEDGE

’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’
Question No. - 2.1 [Nov-2005-14M] [Study Mat.] [RTP-Dec-2019] [RTP-May-2020]
Engineers Ltd. is in the business of manufacturing nut bolts. Some more product lines are being planned to be
added to the existing system. The machinery required may be bought or may be taken on lease. The cost of
machine is  20,00,000 having a useful life of 5 years with the salvage value of  4,00,000 (consider short
term capital loss/gain for the Income tax). The full purchase value of machine can be financed by bank loan at
the rate of 20% interest repayable in 5 equal installments falling due at the end of each year.

Alternatively, the machine can be procured on a 5 years lease, year-end lease rentals being  6,00,000 per
annum. The Company follows the written down value method of depreciation at the rate of 25 per cent.
Company’s tax rate is 35 per cent and cost of capital is 14 per cent.
(i) Advise the company which option it should choose – lease or borrow.
(ii) Assess the proposal from the lessor’s point of view examining whether leasing the machine is
financially viable at 14 per cent cost of capital.
Detailed working notes should be given.
[CMA-RTP-Dec-2013]
Ans: (i) PV of cash outflow under lease = 13,71,630; PV of outflow under Loan = 13,67,083; Prefer Loan.
(ii) From lessor’s point of view, NPV = -47072. Hence leasing the machine is financially not viable.

Question No. - 2.2 [Nov-2007-20M]

ABC Ltd. Sells computer services to its clients. The company has recently completed a feasibility study and
decided to a acquire an additional computer, the details of which are as follows:
(1) The purchase price of the computer is 2,30,000; maintenance, property taxes and insurance will be 20,000
per year. The additional expenses to operate the computer are estimated at 80,000. If the computer is rented
from the owner, the annual rent will be 85,000, plus 5% of annual billings. The rent is due on the last day of
each year.
(2) Due to competitive conditions, the company feels that it will be necessary to replace the computer at the end of
three years with a more advanced model. Its resale value is estimated at 1,10,000.
(3) The corporate income tax rate is 50% and the straight line method of depreciation is followed.
(4) The estimated annual billing for the services of the new computer will be 2,20,000 during the first year, and
2,60,000 during the subsequent two years.
(5) If the computer is purchased, the company will borrow to finance the purchase from a bank with interest at 16%
per annum. The interest will be paid regularly, and the principal will be returned in one lump sum at the end of
the year 3.
Should the company purchase the computer or lease it? Assume (i) cost of capital as 12%, (ii) straight line method
of depreciation, (iii) salvage value of 1,10,000 and evaluate the proposal from the point of view of lessor also.
Ans: PV of outflows under loan = 116927, PV of outflows under lease = 125347.
[Additional expenses  80,000 requires in both option hence irrelevant]

Question No. - 2.3 [Jan-2021-Old-8M]

A Ltd. decided to acquire a machine costing  5,00,000. The expected life of machine is 10 years with no salvage
value. Depreciation will be charged on straight line basis. Tax rate is 30%. The financial manager seeks your
advice for selection between the following two alternatives using Bower–Herringer-Williamson method, using
cost of capital at the rate of 12%.
(i) Leasing: The leasing company is expecting a minimum return of 10% on its investment in leasing
business and lease payment will be received in advance.

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 LEASING DECISION Page 14.9
(ii) Loan: The loan will carry interest rate of 15% and the annual instalment will be paid in advance.
(Round off all calculations to nearest whole numbers)
Present Value t1 t2 t3 t4 t5 t6 t7 t8 t9 t10
PVIF 0.10,t 0.909 0.826 0.751 0.683 0.621 0.565 0.514 0.467 0.425 0.386
PVIF 0.12,t 0.893 0.797 0.712 0.636 0.568 0.507 0.453 0.404 0.361 0.322
PVIF 0.15,t 0.870 0.757 0.658 0.572 0.497 0.432 0.376 0.327 0.284 0.247

BREAKEVEN LEASE RENTAL

Question No. - 3A [Nov-2004-Old-8M] [July-21-Old-8M] [Nov-20-Old-8M] [MTP-Nov-2020/21-6M]
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%.
Required:
Calculate the lease rents to be quoted for the lease for three years.
[CMA-SM]
Ans: Lease Rent to be quoted Y1 =  199.9227 Lakh, Y2 = 133.2818 Lakh, Y3 = 66.6409 Lakh

Question No. - 3B [Study Mat.] [RTP-Nov-2010]

Assuming lease amortized in 5 years, calculate alternate rental structure from the following:
Investment Outlay 100 Lakh
Pre Tax Rate 20%
Scrap Value Nil
Schemes (a) Equal Annual Plan
(b) Stepped Up Plan (15% increase per annum)
(c) Balloon Plan (he pays  10,00,000 for year 1-4)
(d) Deferred plan (deferment of 2 years)
Calculate Lease Rentals.
[As CMA-June-2005- 16 marks]
Ans: (a) LR = 33.434 Lakh, (b) LR = 26.09Lakh, (c) LR = 184.35 Lakh, (d) LR = 68.35 Lakh
Question No. - 3C
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 installments. ‘The lease term is 6 years, with lease rental payable annually
in arrears.
(a) Compute the equated annual installment from the point or view- of HBL.
(b) If the lease rate is unknown, and HBL’s per-tax yield is 25%, what is the minimum lease rent that must be
quoted’? [CMA-SM]
Ans: (a) 4,69,23,573; (b) 6,04,76,463

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 Page 14.10 STRATEGIC FINANCIAL MANAGEMENT
Question No. - 3D
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 machine 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 assest 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. [CMA-SM]
Question No. - 3E
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
15years. 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 Rental
1-5 Normal
6-10 120% of Normal
11-15 150% 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 an 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.
[CMA-SM] [CMA-Compendium] [CMA-RTP-Dec-2013] [CMA-MTP-June-2014-8M]
Ans: Lease Rent per Flat = 3,54,555/6 = 59,092.50

 TEST YOUR KNOWLEDGE

’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’
Question No. - 3.1
Arvind Leasing Company is considering a proposal to lease out a school bus. The bus can be purchased for
8,00,000 and in turn, be leased out at  2,00,000 per year for 8 years with payments occurring at the end of each
year. What should be the yearly lease payment charged by the company in order to earn 20% annual compounded
rate of return before expenses and taxes?
[Given: PVIFA @ 20%, 8 years = 3.837]
Ans: Lease rent = [8,00,000/PVIFA 8 years, 20%] = 8,00,000/3.837 = 2,08,496 p.a.
[CMA-Dec-2014-New-2M]

Question No. - 3.2 [Nov-2019-Old-8M] [Study Mat] [Dec-2021-Old-8M]

With the following data available, compute the BELR that ABC Ltd. should charge from lessee.

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 LEASING DECISION Page 14.11

Particulars Amount
Cost of Machine 150Lakh
Expected useful life 5 Years
Salvage Value of Machine at the end of 5 years 10 Lakh
Rate of Depreciation (WDV) 25%
K0 14%
Applicable tax rate 35%
Machine will constitute a separate block for depreciation purpose.
Ans: After tax Break Even Lease Rental = 32,23,400; Before Tax BELR = 49,59,100

Question No.- 3.3 [May-2015-Nepal-8M] [Study Mat]

The following investment proposal is available to ABC Ltd.:
Particulars Amount
Initial Investment ₹ 3,600 Lacs
Life of Machine 3 Years
Net salvage value of machine after 3 years ₹ 360 Lacs
Depreciation (on written down value basis) 40%

From the above data, calculate Break Even Lease Rental (BELR), if other option of borrowing at an interest rate
of 20% p.a. is available. Further you may also assume that cost of capital is 15% and applicable tax is 30%.
Given:
PVIF @ 15% Year 1 Year 2 Year 3
0.870 0.756 0.658
PVIFA @ 20%, 3 Years – 2.106

Question No. - 3.4 [May-2018-Old-8M]

Front Leasing Ltd. is in the business of providing automobiles on wet lease to Corporate Clients. The company is
considering a new model of battery run Tesla car for which a good number of enquiries is received. The cost of the
vehicle is  25 lakhs. Its operating, maintenance and insurance costs are expected to be  5 lakh in the first year.
Thereafter it will be subject to inflation annually @ 6 percent in the second and third year and @ 4 percent during
fourth to sixth year. The useful life of the vehicle is six years. The net salvage value of the vehicle at the end of six
year will be 10 lakh. Depreciation for Tax purposes will be 40 percent under Written Down Value (WDV) method.
Marginal tax rate applicable is 35 percent. Its cost of capital 8 percent.
You are required to calculate the minimum annual lease rental that the company should quote. Assume that the cost
of negotiation and lease administration is nil.
PVIF @ 8 percent is 0.926, 0.857, 0.794, 0.735, 0.681 and 0.630
Ans: 10,15,022

Question No. - 3.5

A company wishes to acquire an asset costing Rs. 1,00,000. The company has an offer from a bank to lend @ 18%.
The principal amount is repayable in equal 5 year end instalments. A leasing company has also submitted a proposal
to the company to acquire the asset on lease at year end rentals of Rs. 280 per Rs. 1,000 of the asset value for 5

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 Page 14.12 STRATEGIC FINANCIAL MANAGEMENT
years. The asset’s life is estimated at 5 years with residual value of Rs. 10,000 and the cost net of residual value is
depreciated equally each year over its life. Assume that this is the only asset of its class so that at the end of the 5th
year there will be a capital gain or lss with 20% tax effect when the asset is sold. The tax rate of the company is
50%.
For what minimum sale value of the asset at the end of the 5th year will the decision to borrow and own the asset
be preferred to leasing ? Present annual cash flows and arrive at the discounted cash flows for each year showing
salvage value separately. Use PV factors as provided. Round off calculations to the nearest rupee. Assume cash
flows on interest and taxes also at year ends.
[CMA-Dec-2018-8M]

Question No. - 3.6

ABC 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 per annum or by lease. The company wishes to know the lease rentals to be
paid annually which will match the loan option. The following further information is provided to you:
(a) The principal amount of the loan will be paid in five annual equal installments
(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 5 th year. The commission on such sales is 9% on
the sale value and the same will be paid.
You are required to compute the annual lease rentals payable by ABC Ltd. which will result in indifference to
the loan option.
The relevant discount factors are as follows:
Year 1 2 3 4 5
Discount Factor 0.92 0.84 0.77 0.71 0.65
[CMA-SM] [As CMA-Dec-2001-14M] [CMA-Compendium]
Ans: Annual Lease rent = 14,500.

Question No. - 3.7 [May-2003-16M] [MTP-Nov-2013-8M]

Armada Leasing Company is considering a proposal to lease out a school bus. The bus can be purchased for
 5,00,000 and, in turn, be leased out at  1,25,000 per year for 8 years with payments occurring at the end of
each year:
(i) Estimate the internal rate of return for the company assuming tax is ignored.
(ii) What should be the yearly lease payment charged by the company in order to earn 20 per cent annual
compounded rate of return before expenses and taxes?
(iii) Calculate the annual lease rent to be charged so as to amount to 20% after tax annual compound rate of
return, based on the following assumptions:
(i) Tax rate is 40%;
(ii) Straight line depreciation;
(iii) Annual expenses of  50,000; and
(iv) Resale value  1,00,000 after the turn.
[CMA-SM] [CMA-Compendium] [CMA-RTP-June-2014/2015] [CMA-MTP-Dec-2019-8M]
Ans: IRR = 18.75%, Yearly lease payment = 1,30,310, annual lease rent = 2,23,729.

Question No. - 3.8 [RTP-Nov-2011]

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 LEASING DECISION Page 14.13
GMBH is in software development business. It has recently been awarded a contract from an Asian country for
computerization of its all offices and branches spread across the country. This will necessitates acquisition of a
super computer at a total cost of 10 crore. The expected life of computer is 5 years. The scrap value is estimated
at 5 crore. However, this value could even be much lower depending upon the developments taking place in the
field of computer technology.
A leasing company has offered a lease contract will total lease rent of 1.5 crore per annum for 5 years payable in
advance with all maintenance costs being borne by leasee. The other option available is to purchase the computer
by taking loan from the bank with variable interest payment payable semi-annually in arrears at a margin of 1% per
annum above MIBOR. The MIBOR forecast to be at a flat rate of 2.4% for each 6-month period, for the duration
of loan.
Tax rate applicable to corporation is 30%. For taxation purpose depreciation on computer is allowed at 20% as per
WDV method, with a delay of 1 year between the tax depreciation allowance arising and deduction from tax paid.
You are required to calculate:
(a) Compound annualized post tax Cost of Debt.
(b) NPV of lease payment Vs. purchase decisions at discount rate of 4% and 5%.
(c) The break-even post tax Cost of debt at which corporation will be indifferent between leasing and purchasing
the computer.
(d) Which option should be opted for?
[CMA-MTP-June-2015-1+(3+4)+1+1=10]

Question No. - 3.9 [May-2007-old-12marks] [RTP-May-2014] [RTP-May-2021]

A Company is planning to acquire a machine costing 5,00,000. Effective life of the machine is 5 years. The
Company is considering two options. One is to purchase the machine by lease and the other is to borrow
5,00,000 from its bankers at 10% interest p.a. The Principal amount of loan will be paid in 5 equal
installments to be paid annually. The machine will be sold at 50,000 at the end of 5 th year. Following further
information are given:
(a) Principal, interest, lease rentals are payable on the last day of each year.
(b) The machine will be fully depreciated over its effective life.
(c) Tax rate is 30% and after tax. Cost of Capital is 8%.
Compute the lease rentals payable which will make the firm indifferent to the loan option.
Ans: Annual Lease Rental = 1,23,006/-

Question No. - 3.10 [Nov-2009-12M]

M/s ABC Ltd. is to acquire a personal computer with modem and a printer. Its price is  60,000. ABC Ltd. can
borrow  60,000 from a commercial bank at 12% interest per annum to finance the purchase. The principal sum
is to be repaid in 5 equal year-end installments. ABC Ltd. can also have the computer on lease for 5 years.
The firm seeks your advice to know the maximum lease rent payable at each year end.
Consider the following additional information:
(i) Interest on bank loan is payable at each year end.
(ii) The full cost of the computer will be written off over the effective life of computer on a straight-line basis.
This is allowed for tax purposes.
(iii) At the end of year 5, the computer may be sold for  1,500 through a second –hand dealer, who will charge
8% commission on the sale proceeds.
(iv) The company's effective tax rate is 30%.
(v) The cost of capital is 11%.
Suggest the maximum annual lease rental for ABC Ltd.
PV Factor at 11%:
Year 1 2 3 4 5
Discount Factor 0.901 0.812 0.731 0.659 0.593

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 Page 14.14 STRATEGIC FINANCIAL MANAGEMENT
Ans: Maximum lease rental payable at each year end =  16,400.
[Above ans. is calculated using 11% as discount rate. However, you may use borrowing rate net of tax also]

Question No. - 3.11

M/s R Ltd., a profitable company is considering the purchase of a new machine for `75,00,000. The machine’s
useful life is 5 years, with annual maintenance, insurance and administration costs of ` 12 lacs. Depreciation is over
its life on straight line basis, considering zero scrap value. The tax rate is 30%. R Ltd. has a capital structure of 60%
debt and 40% equity. Cost of debt before tax is 8% and the cost of equity is 12%. R Ltd. is interested in leasing out
this machine to a lessee ‘L’ on year end annual lease rents and R will have to maintain the equipment at the costs
stated above.
What should be the lease rents to be billed to ‘L’ for the lease proposal to break-even if:
(i) R Ltd. acquires the machine from its total finance pool.
(ii) R Ltd. uses a bank borrowing specifically for this purpose at 10% interest rate on outstanding principal at
the beginning of each year, with year-end instalments comprising `15 lacs towards principal and balance
towards interest for the year?
Present calculations to the nearest rupee.
[CMA-Dec-2019-10M]

SALE AND LEASE BACK

Question No. - 4A [May-2011-8M]
X Ltd. had only one water pollution control machine in this type of block of asset with no book value under the
provisions of the Income Tax Act, 1961 as it was subject to rate of depreciation of 100% in the very first year of
installation.
Due to funds crunch, X Ltd. decided to sell the machine which can be sold in the market to anyone for  5,00,000
easily. Understanding this from a reliable source, Y Ltd. came forward to buy the machine for 5,00,000 and lease
it to X Ltd. for lease rental of 90,000 p.a. for 5 years. X Ltd. decided to invest the net sale proceed in a risk free
deposit, fetching yearly interest of 8.75% to generate some cash flow. It also decided to relook the entire issue
afresh after the said period of 5 years.
Another company, Z Ltd. also approached X Ltd. proposing to sell a similar machine for  4,00,000 to the latter
and undertook to buy it back at the end of 5 years for  1,00,000 provided the maintenance were entrusted to Z Ltd.
for yearly charge of  15,000. X Ltd. would utilise the net sale proceeds of the old machine to fund this machine
also should it accept this offer.
The marginal rate of tax of X Ltd. is 34% and its weighted average cost of capital is 12%. Which Alternative would
you recommend?
Ans: NPV (Alt-1) =  41,675; NPV (Alt-2) = 53,181

 TEST YOUR KNOWLEDGE

’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’
Question No. - 4.1 [May-2016-8M]
Hi-tech Software Ltd. (HSL) has a complete "Software Developing Unit" costing 70 lakhs. It is this type of block
of assets that have no book value as at 31st March, 2016 as it entitled to 100% rate of depreciation under Income
Tax Act, 1961. The company is facing acute fund crunch as it lacks order from Middle East and was toying with
the idea of taking term loan. Eastern Financier (EF), a reputed finance company, gave the idea of "buy & lease
back" to tide over the fund crunch. EF agreed to buy the software developing unit at  50 lakhs and lease it back to
HSL for lease rental of  9 lakhs p.a. for a period of 5 years. HSL decides to put the entire net proceeds in a fixed
deposit at a nationalized bank at yearly interest of 8.75% for 5 years to generate cash flow much needed for day to
day operation.

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 LEASING DECISION Page 14.15
Central Financier (CF) another financier, gave a proposal of selling a similar software developing unit at  30 lakhs
to HSL and they will buy back after 5 years at a price of  5 lakhs provided the Annual Maintenance Contract
(AMC) @  1.50 lakhs per annum is entrusted to them. The new machine is also entitled to 100% rate of
depreciation under Income Tax Act, 1961. CF also agreed to buy the existing software developing unit at  50
lakhs. HSL would utilize the net sale proceeds to finance this machine.
The marginal rate of tax of HSL is 34% and its weighted average cost of capital is 12%. Which offer HSL should
accept?
Year 1 2 3 4 5
Discounting Factor @ 12% 0.893 0.797 0.712 0.636 0.567

REPLACEMENT WITH BANK & LEASE FINANCING

Question No. - 5A [May-2018-Old-8M] [RTP-Nov-2020-Old]
Robust Tech, an IT company had purchased printers 5 years ago which are due for replacement. The cost of the
printers was  75,00,000 and the company depreciates these class of assets on a straight-line basis for 10 years. The
printers are expected to realize  7,50,000.
There is a proposal to replace all the printers in the company and as a Finance Manager; you are presented with the
following alternatives:

Proposal 1: Purchase a new Class of sophisticated network printers at a cost of  1,00,00,000 which would be
depreciated over a period of 5 years and expected to realize  10,00,000 at the end. The purchase could either be
funded through a loan at 14% repayable in 5 equal annual installments at the end of the year. PVAF at 14% for 5
years is 3.433
OR
Proposal 2: Help Printers Ltd. had submitted a proposal to take over the existing printers and provide on rent the
new class of sophisticated network printers for the next 5 years at an annual rental of  18,00,000 payable at the
end of the year with a clause to increase the rentals by  2,00,000 on an annual basis.
You are required to suggest the best alternative to the management assuming the company's income tax rate is 50%
and discount rate is 7%.
You may ignore realization of scrap value and their short term capital gains/loss under both the options.
Year 1 2 3 4 5
PV @ 7% 0.935 0.873 0.816 0.763 0.713
Ans:

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Page 14.16 STRATEGIC FINANCIAL MANAGEMENT
Important Notes

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