LEASE OR BUY DECISION

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 14% to buy the
machine. The company is in 50% tax bracket.

In case of leasing, the company will be required to pay annual year-end lease rent of Rs. 0.12 million 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. 0.3433 million), the company would have to repay
14% five year loan in 5 equal annual instalments, each installment becoming due at the end of each
year. Machine would be depreciated on a straight line basis, with no salvage value. Advise the company
which option it should go for, assuming lease rents are paid at the end of the year.
SOLUTON :

P.V. of cash outflow under Lease Alternative

Year = 5
Lease payment after tax = 120,000(1-0.5) = Rs. 60,000
Total present value of lease payments = Rs. 2,46,012

Computation of Interest and Principal Components of Loan Installments :

Year installment Interest Adjustment Balance

0 343000
1 100000 48020 51980 291020
2 100000 40743 59257 231763
3 100000 32447 67553 164210
4 100000 22989 77011 87199
5 100000 12208 74991 ---

PV of After Tax Cash Outflows under Purchase Option :

Year Tax Shield Tax Shield Net Cash PV being

On Interest On Dep. Outflows alternative

1 24010 34330 41660 38935

2 20372 34330 45298 39563
3 16224 34330 49446 40363
4 11495 34330 54175 41330
5 6104 34330 59566 42471
202662

Since PV of cash outflow for buying is lower than the leasing alternative. The company should borrow
money and purchase the machine.