Question

Q. 2: A new machine of worth Rs. 1.2 million must have to be installed for being competitive in the market. For the purpose, it approaches a financial instruction to have a 100 percent of loan for the purchase price of the machine which the financial institutions agrees to offer at an interest rate of 13 percent. On the other hand, company has an option to get the machine through a lease financing plan. Considering the information as under:

• The applicable depreciation rates according to 3-years MACRS class life are 33 percent, 45 percent, 15 percent and 7 percent, respectively.
• The annual maintenance charges are estimated to be Rs. 80000.
• The lease terms call for Rs. 300,000 payments at the end of each of the next 4 years.
• The loan amount is to be fully amortized in equal annual installments payable at the end of each year for 4 years.
• The tax rate of the company is 45 percent.
• Under the proposed lease terms, the company should bear the insurance, property taxes, and maintenance expenses.

What is the net advantage of leasing? Should the company take the lease?                  

Answer 1

I) Schedule of cash outflows: Leasing alternative

Year (i)	Lease payment+annual maintenance (ii)	Tax shield on cash outflows (iii) = (ii * 45%)	After tax cash outflows (iv) = (ii - iii)	PVF @ 13% (v)	Present value of lease payment (iv*v)
1	380,000	171,000	209,000	0.885	184,965
2	380,000	171,000	209,000	0.7832	163,689
3	380,000	171,000	209,000	0.6931	144,858
4	380,000	171,000	209,000	0.6134	128,201
					621,712

II) Schedule of debt payment:

Annual payment = Principal*interest rate*[(1+interest rate)^loan period]/{[(1+interest rate)^loan period]-1} = 1200000*13%*[(1+0.13)^4]/{[(1+0.13)^4]-1} = 156000*(1.13^4)/[(1.13^4)-1] = 156000*1.63047361/0.63047361 = 403,433

End of year	Principal amount owing at the beginning of the year	Annual interest @ 13%	Annual payment	Principal amount owing at the end of the year
1	1,200,000	156,000	403,433	952,567
2	952,567	123,834	403,433	672,968
3	672,968	87,486	403,433	357,021
4	357,021	46,413	403,433	0
		413,732

III) Schedule of cash outflows: Debt financing

End of year (i)	Annual payment (ii)	Annual interest @ 13% (iii)	Depreciation (iv)	Tax shield (v) = (iii+iv)*45%	Net cash outflows (vi) = (ii-v)	PVF @ 13% (vii)	Present value of cashflows (viii) = (vi*vii)
1	403,433	156,000	396,000	248,400	155,033	0.8850	137,204.21
2	403,433	123,834	540,000	298,725	104,708	0.7832	82,007.07
3	403,433	87,486	180,000	120,369	283,064	0.6931	196,191.87
4	403,433	46,413	84,000	58,686	344,747	0.6134	211,467.90
							626,871.04

Net advantage of Leasing = Present value of cost of owning - Present value of leasing = 626,871 - 621,712 = 5,159

Since in debt financing cases, nothing given about annual maintainance information, hence assumed no maintainance in this case.