Question

XYZ Ltd., is in the business of manufacturing of steel utensils. The firm is planning to
diversify and add a new product line. The firm either can buy the required machinery or get
it on lease. The machine can be purchased for Rs. 15,00,000. It is expected to have a
useful life of 5 years with a salvage value of Rs. 1,00,000 after the expiry of 5 years and
depreciation on straight line basis. The purchase can be financed by 20 per cent loan
repayable in 5 equal annual installments (inclusive of interest) becoming due at the end of
each year. Alternatively, the machine can be taken on year-end lease rentals of Rs.
4,50,000 for 5 years. Advice the company on the option it should choose. For your exercise,
you may assume the following:
a. Tax rate is 35 per cent and cost of capital is 20 per cent.
b. Lease rentals are to be paid at the end of the year.
c. Maintenance expenses estimated at Rs. 30,000 per year are to be borne by the lessee

Answer 1

The leasing option is the best because Present value of cash outflow is lower than buying/ borrowing alternative.
PV of cash outflows under leasing alternative
Cost of capital after tax = 20% x (1 - 35%)	13.00%
Lease rent after tax = $450,000 x (1-35%)	$292,500.00
PV of cash outflows = 292,500 x PVOA(13%,5) = 292500 x 3.517	$1,028,722.50
PV of cash outflows under buying alternative		Tax advantage
Year	Loan installment	Interet tax shield = 35% x interest	Depreciation tax shield = 35% x dep.	Net Cash Flow	PV @ 13%	Present Value
1	$501,569.55	$105,000.00	$98,000.00	$298,569.55	$0.88	$264,220.85
2	$501,569.55	$90,890.13	$98,000.00	$312,679.42	$0.78	$244,873.85
3	$501,569.55	$73,958.29	$98,000.00	$329,611.27	$0.69	$228,437.14
4	$501,569.55	$53,640.08	$98,000.00	$349,929.48	$0.61	$214,618.30
5	$501,569.55	$29,258.22	$98,000.00	$374,311.33	$0.54	$203,161.19
Less:Salvage value after tax				$65,000.00	$0.54	$35,279.40
					Present Value	$1,190,590.73
Amortization Table
Year	Payment	Interest @ 20% x Ending Bal.	Principal	Ending Bal.
0				$1,500,000.00
1	$501,569.55	$300,000.00	$201,569.55	$1,298,430.45
2	$501,569.55	$259,686.09	$241,883.47	$1,056,546.98
3	$501,569.55	$211,309.40	$290,260.16	$766,286.82
4	$501,569.55	$153,257.36	$348,312.19	$417,974.63
5	$501,569.55	$83,594.93	$417,974.63	-$0.00
		$1,007,847.77
Loan = 1500000	1500000
Rate	20.00%
Period Annual Payment	5
Annual Payment = PMT(13%,5,-300000)	$501,569.55