Problems on Lease and Hire Purchase 1. 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. The purchase can be financed by 20 per cent loan repayable in 5 equal annual instalments (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. 2. The following details relate to an investment proposal of the Hypothetical Industries Ltd., a. Investment outlay, Rs. 180 lakh b. Useful life 3 years c. Net salvage value after 3 years, Rs. 18 lakhs d. Annual tax relevant rate of depreciation, 40 per cent The HIL has two alternatives to choose from to finance the investment Alternative 1: Borrow and but the equipment. The cost of capital of the HIL is 12 per cent, marginal rate of tax is 35 per cent and cost of debt 17 per cent per annum. Alternative 2: lease the equipment from the Hypothetical Leasing Ltd on a three year full payout basis at Rs. 444/Rs. 444/ Rs. 1,000, payable annually is arrears (year end). The lease can be renewed for a further period of 3 years at a rental of Rs. 18/Rs. 1,000 payable in arrears Which alternative should the HIL choose? Why? 3. XYZ Builders Ltd need to acquire the use of a crane for their construction business, and are considering buying or leasing a crane. The crane costs Rs. 10,00,000 and is subject to the SLM of depreciation to a zero salvage value at the end of 5 years. In contrast, the lease rent is Rs. 2,20,000 per year to be paid in advance each year for 5 years. XYZ Builders ltd can raise debt at 14 per cent payable in equal annual instalments, each installment due at the beginning of the year. The company is in the 50 per cent tax bracket. Should it lease or buy the crane? 4. An industrial unit desires to acquire a diesel generating set costing Rs. 20 lakhs which has an economic life of 10 years at the end of which the asset is not expected to have any residual value. The unit is considering the alternative choices of (a) taking the machinery on lease, or (b) purchasing the asset outright by raising a loan. Lease payment (Rs. 2,95,902) are to be made in advance and the lease requires the asset to be completely amortised over its useful period. The cost of debt is worked out at 16 per cent per annum. The lender requires the loan to be re-paid in 10 equal installments becoming due at the beginning of the first
year. Average rate of income tax is 50 per cent. it is expected that the operating costs would remain the same under either method. The firm follows SLM of depreciation and the same is accepted for tax purposes. As a financial consultant, indicate what your advice will be. 5. Alfa Ltd., is thinking of installing a computer. Decide whether the computer is to be purchased outright (through 14 per cent borrowings) or to be acquired on lease rental basis. The company is in the 50 per cent tax bracket. The other data available are: a. Purchase of computer: i. Purchase price: Rs. 20,00,000 ii. Annual maintenance (to be paid in advance) Rs. 50,000 per year iii. Expected economic useful life, 6 years iv. Depreciation (for tax purposes), SLM v. Salvage value Rs. 2,00,000 b. Leasing of computer: i. Lease charges (to be paid in advance): Rs. 4,50,000 ii. Maintenance expense to be borne by lessor iii. Payment of loan: 6 year-end equal installments of Rs. 5,14,271 6. ABC Machine Tool Company Ltd is considering the acquisition of a large equipment to set up its factory in a backward region for Rs. 12,00,000. The equipment is expected to have an economic useful life of 8 years. The equipment can be financed either with an 8-year term loan at 14 per cent interest repayable in equal installments of Rs. 2,58,676 per year, or by an equivalent amount of lease rent per year. In both cases, payments are due at the end of the year. The equipment is subject to the SLM of depreciation for tax purposes. Assuming no salvage value after the 8 year useful life and 50 per cent tax rate, which of the financing alternative should it select?
