Problem 13.

1 f R 1 00 000 with borrowed fund

A f rrm h as t I1e c h oice of buying a piece of equ1pmen
· tat a cost O s.or 'to take
' on lease t he same O 5a· 1

a cost of 1896 p.a. repayable in five annual instalments of Rs. 32,000' nar,
annual rental of Rs. 32,000. The firm is in the tax-bracket of 0%. 4
Assume:
(i) The salvage value of the equipment at the end of the period is zero.
(ii) The firm uses straight line depreciation.
(iii) Discounting factors are:
@996 0.917 0.842 0.772 0.708 0.6Sij
@ 1196 0.901 0.812 0.731 0.659 0.59J
@ 1896 0.847 0.718 0.609 0.516 0.43i
Which alternative do you recommend ?
Solution
Cost of Borrowed Funds:
1(1-T) 1896(1 - 0.40)
= 1896 (0.60) - 10.896 say 11 96
 Ch 11p tt!r 13 Lea~e or Buy Decisions
43 1
. of Cusl of Owning
l .,lJOl1
pl.I,., --
- - --- - - - - ---- ·-
(R s.)
coifl ------- Annual l rllcrcsl Arnorli -
/
---
)'c:JP
.
payment
---- - --
~a tiun
lkrrcc i;,.
I ir,11
Ti.11<
.'> a ving ~
Co<. 1 r, f
uv. n1r, ~
~ -----3 2' 000 18,000 14,000 20,000 15,200
I 5.480 16,800
I 32.000 16,520 20,000 14, 192 17,808
2 32,000 12,506 J 9,494 20,000 13.002 18,998
J 32,000 8,997 23,003 20,000 11,599 20,401
4,857
-'
5 --
J I.840
J,59,840 59,840
26,983
1,00,000
20,000 9,943
- -· 21 ,897

---- --
rot.ii

crt'rnen
tal Cost of Leasing Over Cost of Owning
~ - :__----- Cost of Net lease
1,00,000 63,936 95,904

(Rs.)
Advantage D.F. Present value
\'rars owning case of owning

------
@ 11 96 of ad vantage
16,800 19,200 2,400 0.901 2,162
I l 9,200
17,808 1,392 0.812 l. 130
2 19,200
18,998 202 0.731 148
3
20,401 19,200 (1,201) 0.659 (7 91)
4
21,897 19,200 (2,697) 0.593 (1 ,599)
5
i, 95,904 96,000 96 1,050
Total
e
·s .Jt is advantageous to purchase the asset on borrowed fun ds as the present vaJue of advantaoes
Ana IySl ' e
is positive.
problem 13,2
The FFM Ltd. is in the tax_ b_rac_ket of 3596 and di~counts its cash flows at 1696. In the acquisition of an
et worth Rs. I 0,00,000, 1t 1s given two offers - either to acquire the asset by taking a bank loan @ 15%
] ;~~ repayable in five yearly i~stalments of Rs. 2,00,000 eac_h plus inter~st or to lease-in the asset at yearly
entals of Rs. 3,24,000 for five years. In both cases, the mstalment 1s payable at the end of the year.
~pplicable rate of depreciation is 1596 using 'written down vaJue' (WDV) method.
You are required to suggest the better alternative.
- 2 3 4
Year l 5
P. V. factor @ 16% 0.862 0.743 0.641 0.552 0.476

Solution
Alternative I : Acquire the Asset by taking a Bank Loan (Rs.)

Years l 2 3 4 5
Interest(@ 1596 p.a.) (a) 1,50,000 1,20,000 90,000 60,000 30,000
Depreciation (@ J 5% WDV) 1,50,000 1,27,500 1,08,375 92,118 78.301
3,00,000 2,47,500 1,98,375 1,52,118 1,08.301
Less: Tax shield (@ 35%) (b) 1,05,000 86,625 69,431 53,2 4 I 37,905
Interest less tax shield (a) - (b) 45,000 33,375 20,569 6,759 (-)7,905
Principal repayment 2,00,000 2,00,000 2,00,000 2,00,000 2,00,000
Tota) cash outflow 2,45,000 2,33,375 2,20,569 2,06,759 1.92,095
Discount factor(@ J 6%) 0.862 0.743 0.641 0.552 0.476
Present value 2, 1l, 190 l ,73,397 1,41,385 1,14,131 91.43 7

P.V. of total cash out flow = Rs. 7.3 1,540

432 Part On e ·. pnnc1ples
• .
of Financial Management

Alternativ
~ Il . . Ass1.' t o n Leas1.: Basis
uu-e . . -·- - -- (~
Year --- - . . - -- - ·N·cl ca; h @ 35'Hi ___Dis~~un ~ o
_u_, f!r1 w fl.I/,
Ta~ shield -
~ -- Rentals . f11: ,
- - - - - -- - - 2.1 0,600 -- 0.862 - 1.k\ ,' ,
3,24,000 ___ . I, 13,400 0.743
2 2, l 0,600 I,S n:~;,
3,24,000 I , 13,400 0.641
3 2, I0,600 I,14 :,, .
3,24,000 1, 13,400 0.552
4 2, 10,600 I,lc,i'.
3,24,000 1,13,400 0.476
5 2, 10,600 l ,~Xl.~
~ - - -~ 3,2~4~,0~00~ - -~l~,1~3,~40~0~ - - _ : .~ : . . _ _ - - -- - -- -
P.V of total cash outflow under lease option = Rs. 6,89,50 5
Anatis: By making analysis of both the above alternatives, we ca~Oo b;er~e8~h;i~t1resent _valueof ,
cas outflow 1s lower in Alternative II by Rs. 42 035 (i.e. Rs. 7,3 l ,5 · s. ' ' · ence it 15 sugge<.i '
to acquire the asset on lease basis. · ,._

Problem 13.3
DLP Pvt. Ltd. is considering the possibility of purchasing a ~ultipurpose machine which cost Rs.i·
lakhs. ~h~ machine has an expected life of 5 years. The machme gener~tes Rs. lakhs per year befoi
6
th nd 5
d~preciation and tax, and the management wishes to dispose _the_machine at · e e of years Whi;
will fetch Rs. 1 lakh. The depreciation allowable for the machine is 2 596 on wntten d~wn value and 111L..
com. pany 's tax rate is 50%. The company approached a NBFC for a f'1ve year Iease f or f mancing
· the ¾e-t
w~ich quoted a rat~ of Rs. 28 per thousand per month. The c?mpany wants you to ev~u~te the pro~
with _purchase option. The cost of capital of the company 1s 1296 and for lease option It wants yo
consider a discount rate of 1696. UI!,

0 2 3 4
PV@ 1296 1.000 0.893 0.797 0.712 0.636 0.56)
PV@ 1696 1.000 0.862 0.743 0.641 0.552 0.4lo

Solution
Evaluation of Purchase Option (Rs. lakhs1
Particulars 0 2 3 4
Initial outlay (10)
Operating Profit 6.00 6.00 6.00 6.00 6.(11
Less: Depreciation 2.50 1.88 1.40 1.06 O.ll
Profit before tax 3.50 4.12 4.60 4.94 5.11
Less: Tax @ 5096 1.75 2.06 2.30 2.47 2.f!J
Profit after tax 1.75 2.06 2.30 2.61
2.47
Add: Depreciation 2.50 1.88 1.40 1.06 O.ll
Salvage value of machine
l.00
Net cash Inflow 4.25
Present value factor @ 12% 1.00 0.893 -0.797
3.94 3.70 3.53
-4..\0

Present values ( I0) 3.80 3.14

0.712 0.636
-
0.56;

Net present value of the purchase option is Rs. 4,31,000.

2.63 2.25
-2.41
 Chapter 13 Ledse or Buy Decisions 433
Evaluation of Lease Optio n
(Rs. lakhs)
Particulars
2 3 4 5
Operating profit 6.00 6.00 6.00 6.00 6.00
Less: Lease rent 3.36 3.36 3.36 3.36 3.36
Profit before tax 2.64 2.64 2.64 2.64 2.64
Tax @ 50% 1.32 1.32 1.32 1.32 1.32
Profit after tax 1.32 1.32 1.32 1.32 1.32
Discount factor@ 1696 0.862 0.743 0.641 0.552 0.476
Present values 1.14
- 0.98
-
0.85 0.73 0.63
The net present value o f lease option is Rs. 4,33 ,000.
, Analysis : From the an alysis of th e ab ove we can observe that NPV of lease option is more than that of
purchase option . Hence, lease of machine is recommended.

Problem 13.4
Diligent Ltd. is considering the lease of an equipment which has a purchase price of Rs. 3,50,000. The
equipment h as an estimated economic life of 5 years with a salvage value zero. As per the income-tax
rules, a written down d epreciation @25% is allowed. The lease rentals per year are Rs. 1,20,000. Assume
that the company's corporate tax rate is 50%. If the before-tax rate of borrowing for the company is 16%,
should th e company lease the equipment ? ·
Note - Present value of Re. l for 5 years are:
Year l 2 3 4 5
~ ~
P.V. @8% 0 .9259 0.8573 0.7938 0.7350 0.6806
O.t P.V. @16% 0 .8621 0.7432 0.6407 0.5523 0.4761
~
Solution
Calculation of Tax shield on Depreciation •
Year l 2 3 4 5
Balance in the beginning 3,50,000 2,62,500 1,96,875 1,47,656 1,10,742
Depreciation (@ 25% WDV) 87 ,500 65 ,625 49 ,219 36,914 27,685
Balance at the end 2,62,500 1,96,875 1,47 ,656 1,10,742 83 ,057
Tax shield on depreciation @ 50% 43,750 32,813 24,610 18,457 13 ,843
-'
Evaluation of Lease d ecision (Rs.)
Year Lease rentals Tax shield on Total cash Discount Present values
(after tax) De,-preciation lost outflow factor @ 8%
r
1 60,000 43 ,750 1,03 ,750 0.9259 96,062
2 60,000 32,813 92,8 13 0.8573 79,569
3 60,000 24,610 84,610 0.7938 67,163
-' 4 60,000 18,457 78,457 0.7350 57,666
60,000 13 ,843 73 ,843 0 .6806 50,258
5
3,50,7 18
Present value of total cash outflow

NPV =
3,50,000 . 3,50 ,718 == R s. 718 (n egative) . . .
Suggestion _ Since NPV is negative, il is suggested to purchase the equipment to mm1m1ze the cash
outflow.
 434 Part One : Principles of Financial Managemen t

Problem 13.S
ABC Finance Ltd . is a hire purchn sl' a11d leasi ng con1pany. fl has bccr'. ~1rp 1 o,,chl' cl by a ~rr, all h,1~ir,.. ,.,
firm interested in acquirin~ ,\ 111arhinl' through leasing. The qu?tcd pnct: uf th e macl 11 ri c '" k r.. S/)(J,()(J(J
1096 sale tax is extra. The lcusc will be for a primary lease pc nod of 5 year~.
The finance company wants 8~ post-tax return on the outlay. Its effective tax r~tc is J5'J6. Th ~ inu,,,11
tax rate of dcpn:cinlion on the mac hine is 25% (WDV). Lease rents arc payable in arrear ar Ilic c:nd ,);
each yea r.
Calculate th e annual rent to be charged by ABC Finance Ltd.
Solution
Determination of Cash outflows (Rs.J
Cost of machine inclusive sale tax (1096) 5,50,00Q
Less: Tax saving on Depreciation (Tax shield Relief)
Present value of cash outflows for purchase --
1,22,284
4,27,716

Computation of Tax Saving on Depreciation of the Machine

Year Cost / WDV Depreciation Tax PV factor P.V. of Dep.
@2596 @3596 @896 tax shield
1 5,50,000 1,37,500 48,125 0.926 44,564
2 4, 12,500 1,03,125 36,094 0.857 30,933
3 3,09,375 77,344 27,070 0.794 21 ,494
4 2,32,031 58,008 20,303 0.735 14,923
5 1,74,023 43,506 15,227 0.681 10,370
--
3.993 1,22,284

Calculation of Leasing Rent

Let, the required lease rent per year be 'R'
.-. Post-tax rental income p.a. (1 - 0.35) = 0.65R
P.V. of 5 year's post-tax rental income = 0.65R X 3.993
This sum should be equal to Rs. 4,27,716
0.675R X 3.993 = 4,27,716
R = 4,27,716/2.59545 = 1,64,795
Hence, the annual rent to be charged by ABC Finance Ltd. is Rs. 1,64,795 .

Problem 13.6
Hypothetical Ltd. is planning to have an access to a machine for a period of 5 years. The company can
either have an access through the leasing arrangement or it can borrow money at 1496 to buy the
machine. The company is in 5096 tax bracket.
In case of leasing, the company will be required to pay annual year-end lease rent of Rs. l,20,000 for 5
years. All maintenance, insurance and other costs are to be borne by the lessee.
In case of purchasing the machine (which costs Rs. 3,43,300), the company would have to repay 14%fire
year loan in 5 equal annual instalments, each instalment becoming due at the end of each year. Machine
_would be depreciated ~n a straight line basis, with no salvage value. Advise the company which opl ion
1t should go for, assumrng lease rents are paid at the end of the year.
~
Chapter 13 Lease or Buy Decisi ons 43 5

solution ·I utfl ow under Ll' aSL' i\lll'nwti vL·

V of Ca~ , _o_ - . --· - -
~ _ • - ·-· L~sc payment PV Iac tor at u f1 cr To ta l P V of lea~(:
yc11 r t.' llJ after ta x ( I · O.S) l ax co sl o f ck b1 70/, r aymc nt ..s
Rs. 60,000 4.1002 Rs. 2.46 .0 12
I.5
-· . f lnll'l"l'SI and Prin cip3I Compon ents uf Loan In sta lment ( R ~.)
C() lllPLlt ;1IHlll O -- - - ~----- ------------- -- ----
- Loa n Loan at th e Payment Prin cipal
Y<':, r Instalment beginning of Interes t on Prin cir al r, ut'-1.i ndin g
t· nd (Rs.) the year loan re pay m e nt ;.1 1 1h e e nd ol
1h c year

--- ----
I
1,00,000
1,00,000
3,43,000
2,91 ,020
48,020
40,743
51,980
59,257
2,9 1,020
2,3 1,763
2
1,00,000 2,31,763 32,447 67,553 1,64,210
3
1,00,000 1,64,210 22,989 77 ,011 87 ,199
4
1,00,000 87,199 12,208 74,991
5
Loan Instalment
Amount of Loan
1 Rs. 3,43,300
Rs. 1,00,000
= PV factor of nnnuity of Re. 1 for 3.433
S year at 1496 rate of interest
PV of After Tax Cash Outflows under Purchase Option (Rs.)

Loan 'fax Tax Net cash PV factor PV of being

Year
instalment shield shield outflows al 70/:i alt ernative
end
(Rs.) on interest on Dep.

l 1,00,000 24,0lO 34,330 41 ,660 0.9346 38 ,935

2 1,00,000 20,372 34,330 45,298 0.8734 39,563

3 1,00,000 1
16.224 34,330 49,446 0.8163 40,363
4 1,00,000 1
11,495 34,330 54,175 0.7629 41 ,330
5 1,00,000 6,104 34,330 59,566 0.7130 42,471
2,02 ,662

Recommendation -Since PV of cash outflow for buying is lower than the leasing alternative. The compan y
should borrow money anil purchase the machine.

Problem 13.7
ABC Limited is considering to acquire an additional sophisticated computer to augment its time-share
computer services to its clients. It has two options :
Either, (a) to purchase the computer at a cost of Rs. 44,00,000
Or, (b) to take the computer on lease for 3 years from a leasing company at an annual lease rental
of Rs. 10 lakhs plus 1096 of the gross time-share service revenue. The agreement also
requires an additional payment of Rs. 12 lakhs at the end of the third year. Lease rentals
are payable at the-. year.end and the computer reverts back to lessor after period of contract.
The compan y estimates that the computer will be worth Rs. 20 lakhs at the end of the third year.
The gross revenue to be earned are as follows:
Year 2 3
Rs. in lakhs 45 so 55
436
Part One : Principles of Financial Management

Annual O pcratmg
l
·
cost (l'xc 1u<.1.mg t 1cprccratu,n
. . /I t:.is
,. .,,... 1-,·nt
'- al) arc
. .estimated at "-S.n
18
·~ldd't• l · ·
1 1ona cost of Rs . 2 lakh s for slarl ur and trarnrn g a . t thc begrnntng of the fir s Year Tlakh \
t
to be borne by thl' lessee in rnsl· of lcnsc arrnngcrncnt also. The company proposes, O· he&t ~'b:,
·tnkn.'st to r·rnarKl'
· th e purclwsr of·th e computer ..,Hl cl th l, rcJJaymcnts are to be mad e asp..6Ottov,c~, ,~
sc hl.'duk : ·•· ·- ----
"rth "'
cr(ilj,
- lnt C' res t for year -- ----------,. \
Ycn r l'lld Repayment of principal . _____ _
1 - - --- ----- ! 0~00,000-- II 7,04,000 ----------- ------ 1·!Jli.i!;
2 17,00,000 5,24,000 17.~
3 17,00,000 2,72 ,ooo 22.~:
-- - --- - --- - lr; ,t
1
For the purpose of this computation assume that the company uses the straight 1.. .___ · ·1
. . inc 1
depreciation on assets and pays 5096 tax on its mcome. rr eth,,
th
You are required to analyze and recommend to the company which of e two options . b ·
Year 1 2- - -~ tt~
-.. . _'
P.V. factor@ 896 0.926 0.857
P.V. factor@ 1696 0.862 0.743

Solution
Rs. 44 lakhs - Rs. 20 lakhs
Depreciation p.a. Rs. 8 lakhs p.a.
3 years
Tax advantage on depreciation p.a. = Rs. 8 lakhs X 0.50 Rs. 4 lakhs p.a.
Tax advantage on interest paid = 1696 (1 · 0.50) 896

Present Value of cash outflow under Leasing Alternative

Year Lease rent 10% of gross Total payment Tax shield Net<i:ash PV factor -
h.:
(Rs.) revenue (Rs.) @ 5096 outflow (Rs.) @8% -~
1 10,00,000 4,50,000 14,50,000 7,25,000 7,25,000 0.926 t.
2 10,00,000 5,00,000 15,00,000 7,50,000' 7,50,000 0.857 tr
3 10,00,000 5,50,000 27,50,000 13,75,000 13,75,000 0.794 10· .
3 Lump sum 12,00,000
Total Present value 1~ l;

Present value of Cash outflow if Computer is bought

Year Initial Interest Total Tax Tax shield N.et ,ash PV factor L-
payment @ 16% shield on on Depre- outflow @ 8~

_______________________
(Rs.) (Rs.)
(Rs.) Interest ciation (Rs.)
___:__~--- --~-;~:
10,00,000 7,04,000 17,04,000 3,52,000 4,00,000 9\52,000 0.92t-
17,00,000 5,24,000 22,24,000 2,72,000 0.857 ,;_:
2 4,00,000 15,SZ,000
3 17,00,000 2,72,000 19,72,000 1,36,000 4,00,000 14,36,000 0.79-l
3 Salvage (20,00,000) Q} L) .j r ''
Total present value
Suggestion - The present value cash outflow is less by Rs. 6,42,~;~) (i .~.-~ 2.;~;-~;n---·m,t:
computer is bought. Therefore, purchase of computer is suggested .
Problem 13.8 .,
Alfa Ltd. is thinking o~ insta'.ling a com~uter. Decide whether the rnm putrr i_s_ro be ~\~-1~,h~~~\,·
(through 15% borrowmg) 01 to be acquired on lease rental ba sis. The rate o1 1n c oni t
at 40%. The other data available are as under:
P11rclwsc of Crnnpul l' r
Chapter 1l Leas, or Buy Decls 1oni 43 7
'
Purl'lins1: price
i\n1111nl mninlt'IH\lh'I.' (to hr 1, .11 1 , H"· 2O,0() ,000
' ( Ill l H 1\l [lllt' l ' )
Expert ed l'l.'onrn11ir wu: 1111 Iii\' R!i. 11\0,ooo r>n y1·.i r
(, Y(' !ll ,I\
lkprcc intion (lor tnx pmpos\•s )
Si\l\' ,'11. l' \' i lhll'
St r;ii 11, li1 11 11 l' nH•thocl
R!-.. 2.00,000
LL'a~,11 ~ of (\rn1pull'r
LL·nsr chargl'S lu be paid i11 advance
Rs. 4,S0,000
Mni111l·11ancc cxpL'IIScs to be borne by lessor

r'n yrncnt of loan: 6 year-end equal instalments or Rs. 5,28,474.

N~tc__:_~rcsent value of Re. I for six years
Year P.V.@ 6%
P.V.@ 99ri P.V. r,. , I 1'lf,
I 0.9434 0.91~ - - --
2 0.8 696
0.8900
0.8417 0.756 1
3 0.8396 0.7722 0.657 j
4 0.7921 0.7084 0.571 8
5 0.7473 0.6499 0.4972
6 0.7050 0.5963 0.4323
Solution

I
Calculation of Interest on Loan
(R s.)
Year loan a l Loan Interest Principal Prin cipal
end the b eginning instalment on loan repayment out standing at

I
of the year
the year end
I 20,00,000 5,28,474 3,00,000 2,28,474 17.71 ,526
2 17,71,526 5,28.474 2,65,729 2,62.745 15,08.781
3 15,08,781 5,28,474

I
2,26.317 3,02 , I 57 12,06,624
4 12,06,624 5,28,474 1,80,994 3,47,480 8,59,144
5 8,59,144 5,28,474 1,28,872 3,99,602 4,59,542
6 4,59,542 5,28,474 68,932 4,59,542
20,00,000 - 2,00,000
Annual depreciation=

Year end Principal

repayment
6
Calculation of Present Value of Cash Outflows if Computer is Purchased Outright
Int erest after
tax saving
=

Tax saving
Rs. 3,00,000 p.a.

on depreciation
Net cash
outflow
Discount
factor @ 9%
Present
values
(Rs.)
'
(I) (2) (3) (4) (2)+(3) - (4)
2,28,474 1,80,000 1,20,000 2,88,474 0.9174 2,64,646

~
2 2,62,745 1,59,437 1,20,000 3,02,182 0.8417 2,54.347
1,35,790 1,20,000 3,17,947 0.7722 2,45,5 19
3 3,02,157
1,08,596 1,20,000 3,36,076 0.7084 2,38~07b
4 3,47,480
1,20,000 3,56,925 0.6499 2,3 1,960
5 3,99,602 77,323
1,20,000 3,80,901 0.5963 2. 2i .13I
6 4,59,542 41,359
I-H,l .bS5
1,19,260
I.e.,,: P.V . of salvage valut.: (Rs. 2,00,000 X 0.5963) -- -

I 3A2.4 25
P.V. rJf c ac. h ()U t flo w -- --~- - - --
- - - ----·

-- --
 438 Part One : Principles of Financial Management

Calc ulation P.V. o~ash out fl ows_is com pull'r is I a ken !J ll Lcasl' ha sis
Year Ll'asc re nt l' .V. f ; 1c l tJ 1
end (aft er t ax savi 11 ~~ ) (l/J 9%
0 4,00,000 1.000
I -5 2,40,00() .1.HR9h
6 ( 1,60,000) 0.)%.1
P.V. of cash ou lflow
- -- --- - -- --
Assumption - Tax advantage is acc rued a t th e end of th e year.
Analys is - The presen t val ue of cash outfl ow is lowest if computer is taken on lease ba <i i 11
suggested to acqu ire computer on lease basis. ' ,.,,,e ,
Problem 13.9
ABC Ltd. is considering a proposal to acquire an equipment costing Rs. 5,00,000. The expected ff
life of the equipment is 5 years. The company has two options - eith er to acqu ire it by obtainii ~'-tr
of Rs. 5 lakhs at 12% interest p.a. or by lease. The follo wing additional info rmation arc availii2 lf
(i) the principal amount of loan will be repaid in 5 equal yearly instalm ents.
(ii) the full cost of the equipment will be written off over a period of 5 years on straigh t line basi
it is to be assumed that such depreciation charge will be allowed fo r tax purpose. ~ an(
(iii) the effective tax rate for the company is 4096 and the after tax cost of capital is I0%.
(iv) the interest charge, repayment of principal and the lease rentals are to be paid on the last dayof
each year.
You a re required to work out the amount of lease rental to be paid annually, which will ma tch the loan
option. The discount factor at l 096 are as follows:
Yeu l 2 3 4
Discount factor 0.909 0.826 0.751 0.683 0.621

Solution
Calculation of Interest under Loan Option and Depreciation (Rs1

Principal amount Repayment Principal at Interest for Depreciation

Year
at beginning of year at end of year end of year year @ 12% fo r year

1,00,000 4,00,000 60,000 l ,00,000

l 5,00,000
1,00,000 3,00,000 48,000 1,00,000
2 4,00,000
2,00,000 36,000 1,00,000
3,00,000 1,00,000
3 24,000 1,00,000
1,00,000 1,00,000
4 2,00,000 1,00,000
1,00,000 Nil 12,000
5 1,00,000
(Rs I

Calculation of Present Value under Loan Option

Total Net outflow Discowll \1PI
Total Tax on Interest
Year Repayment Interest (3) - (c)
factor____
depreciation (a)+(b)
of principal on loan (1 )+(2)
(a) (b) (c) - ----- - -r· _\.J
(I) (2) (3)
96,000 O.<X:N
64,000
l ,00,000 60,000 1,60,000 40,000 24,000
[l6~ t-
-:u~,
59,200 S~.80ll
40,000 19,200 c- I ;S;
2 1,00,000 48,000 1,48,000 (1 i :i I
5-1.400 K!t.C)(J
40,000 14,400 ~t1 ~I'
3 1,00,000 36,000 1,36,000 7 l -l('ll.l l)~.'i>
9,600 -1 9,600 ~ 1;;•
J ,24,000 40,000 n c;,1 l
4 1,00,000 24,000 t' i,.'l\)
'1,800 44 ,1-100
l,l2,000 40.0U0 , ii.JO
.1, 1J .;..l
5 1,00,000 12,000
Total present value of cash out0ows
 Chapter 13 L~ .Jse o r Buy Dec1s1o n, 439

Annual cas h o utfl o w aft cr- ta :x = 3. 14,44 1/ 3.790 = f{~ . 82 ,966

Annual least' rental whi c h will be indiff c n :nl tu loan option :c:: 82,966
I . 0.40
= R~. J .38., 277
problem 13.10

A fac torv need s an ('quiplllL' nt fo r use. It ha s th e o ption o f outright purch ase o r lca!-.ing the eq ui pm e n t
Data are g i\'e n hd o w . Recomm e nd the best option that the factory should c hoose .
Option I
Purc ha se out1ight for a cost of Rs. 80 lakhs. It is to be entirely financed by a term loan @ J8<1;) p.a. inlerc5t
on out standing pa yable on a yearly basis. The term loan to be repaid in eight equal ins talm e nts of
Rs. IO lakhs ea c h , beginning from second year-end. The economic life of the equipment is assessed to
be ten year. The eq u ipment will b e depreciated @ I 0% p.a. on straight line basis, with insignihcant
salvage ,·alue at the end of the economic life? The estimated maintenance expenses would be as d etailed
below:
Year 2 3 4 5 6 7 8 9 10
MC" 4.00 4.40 4.88 5.47 6.18 7.05 8.11 9.4 l I 1.01 13 .00
(') MC - Maintenance cost in Rs. lakhs.
Option 2
The equipment may be leased for a ten-year period. The maintenance of the equipment wiU be done by
the lessor. The lessee has to pay Rs. 18 lakhs annual rental at the beginning of each year over the lease
period.
Note - Ass u me that the lessee is in a tax bracket of 5096 and a verage cost of capital of the lessee firm as
1496 p.a.
Present value factors for discounting at 1496 p.a. given below may be used for ready reference :
1 2 3 4 5 6 7 8 9 10
0.877 0.769 0 .675 0.592 0.519 0.465 0.400 0.351 0.308 0.270

Solution
Option I : Purchase (Rs. lakhs)
Year Loan Amount Interest Mainte- Interest + Tax Outflow Total
repaid b alance on balance nance Maintenance saved Interest + outflow
Cost + Depreciation 50% Maintenance

I 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 I 2.13 4.14 14.14
10 40 9.00 6. 18 23 .18 11.59 3.59 13 .59
5
30 7.20 7.05 22.25 22 .25 11.13 13 .13
6 10
20 5.40 8.11 21.51 10.76 2.76 12 .76
7 10
3.60 9.41 21 .01 10.50 2.50 12.50
8 10 10
1.80 l 1.0 I 20.81 I 0.41 2.41 I 2.41
9 10 0
13.00 21.00 10.50 2.50 2.50
10
 440 Part One : Principles of Financial Management

Calcula tion of Presen t Va lue

-----. ·--
Yea r To ta l cash o u tflO\,v
---- - - - --- Der (w 14'1i,
5.20 --
, ,.t,_(~\ I~¼
3
2 15.40
14.74
0.877
0.769
cri ,

4.\6
~, .

0.675
4 14. 14 11 .~~
13.59
0.592
5 <)_<)~
0.5 ) 9
6 13.13 k.3,
0.465
7 12.76 '-Os
0.400
8 12.50 6.1I
0.351
9 12.41 S.10
0.308
10 2.50 4.39
0.2 70 3.82
Total present value of cash outflows
0.67
Option II : Lease -:--:-..::..'..

~------T~
Year ; ; - -- - - - ; -
Lease Le:a:s-::
e -=-re=-::n:-=-t______ _ _ _ _ (Rs. lakhs) ~
r ent DCF
after tax shield @ Prese
1- - -- -- - -tt1
18 -- -----~.~ - - - - - - - ~ ~1496 ~- valu111
9
2 18 1.000 ~
3 18 9 0.877 9.oo
9 0.769 7.89
4 18
9 0.675 6.92
5 18 9 ~00
6 18 0.592
9 S.33
7 18 0.519
9 4.67
8 18 0.465
9 4.19
0.400
9 18 9 3.60
0.351
10 18 9 3.16
0.308
2.77
_T_o_ta_l~p_r_e_se_n_t_v_a_l_u _e _o_f_c_a_s_ho_u_t_fl_o_w_s_ _ _ __ _ _ __ _ __ _ _ _ __ _ _ __ --.:..:_53.
60
Analysis _ The present value of net cash flows is lowest for lease option, hence it is suggested to~
eq uipment on lease basis.