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YEAR END Lease rent after taxes (LR(1-t)] PVIFA at 13% Total PV
Schedule of Depreciation
Year Dep Bal. at the end of the year
1 1500000*.25=375000 1125000
2 1125000*.25 843750
3 843750*.25 632813
4 632813*.25 474610
5 474610*.25 355958
2. ABC Company Ltd., has two financial options in respect of procuring an Equipment
for utilizing the same for 5 years costing Rs. 10,00,000. The two options are:
Option 1: Borrow Rs. 10,00,000 at an interest rate of 15%. The loan is repayable at 5
year end instalments. The equipment could be sold at the end of its 5 year economic life
at a realisable value of Rs. 1,00,000.
Option 2: lease in the asset for a period of 5 years at yearly rental of Rs. 3,30,000
payable at year end. The rate of depreciation allowable on the equipment is 15%. The
company has to pay Income Tax @ 50% and has a discounting rate of 16%. Capital gain
or loss is to be ignored. Evaluate the two options and give your opinion.
(Hint: purchase option: Rs. 5,78,164 and Lease option: Rs. 5,40,210)
Solution:
The two options before the company can be evaluated as follows:
Option IPurchase of equipment out of borrowed funds. In this case the company shall
have to pay interest every year together with the repayment of part of the borrowing.
The company however will get tax shield for both the interest paid as well as for
depreciation. The resultant cash flows may be evaluated as follows:
YEAR INTEREST DEP INT.+DEP TAX REPAYMENT NET PV
@.15 SHIELD CASH
ON @.16
INT+DEP
1 150000 150000 300000 150000 200000 200000 -172400
2 120000 127500 247500 123750 200000 196250 -145814
3 90000 108375 198375 99188 200000 190812 122310
4 60000 92120 152120 76060 200000 183940 -101535
5 30000 78300 108300 54150 200000 175850 -83705
5 SCRAP +100000
VALUE
47600
NET PRESENT VALUE OF OUTFLOWS: 578164
OPTION II: In this case the company has to pay a lease rental of rs. 3,30,000 on which tax
shield will be Rs. 165000. So the annual net outflow will be Rs. 165000 only for 5 years.
The PVAF for 16% for 5 years is 3.274. the pv of outflows may be ascertained as follows:
PV OF OUTFLOWS= 165000*3.274= 540210
SINCE OV OF OUTFLOWS IS LOWER IN LEASING OPTION, IT IS BETTER TO GO FOR THIS.