Page 1 of 2 GH Patel Post Graduate Institute of Management Financial Decision Analysis Leasing and Hire Purchase-SEMESTER IIT Prof. (Dr.) Paresh Shah Email: profpareshshaheyaho: ghipibmerprofparesh.in CRE 1 Hero Honda Manufacturing Company desires to acquire the services of machinery worth Rs.55,000. The machine can be bought with a Rs 5,000 down payment and 10 annual payments at 6 per cent, using the steady payment method. In case the company owns the machine, it will receive an investment allowance of Rs.13,750 in the year zero and will realise salvage value of Rs.10,000 from the sale of the machine at the end of 10 years. The company uses straight line depreciation to a salvage value of zero over 10 years. The company has the option of leasing the machinery with no initial payment at annual payments of RS7,500 for 10 years, The company’s cost of capital is 10 per cent. The corporate tax rate is 50 per cent, Should the company lease or buy? CRE 2 Raj Kamal Retail Company is considering a proposal of buying a centrally located building suited to its needs. Itcan purchase the building and sell outright for Rs-8.16 lakh. Ifit purchases the property, it expects to be able to raise a first mortgage loan of Rs.6 lakh for 21 years at 8% followed by 21 years Joan for Rs. Jakh at 8%, At the end of 42 years the value of the property will be reduced to a minimum of Rs44 lakh, due to its location, The other alternative before the company is that the company may lease it for 21 years at Rs.1,20,000 per annum with option to renew the lease at Rs-80,000 per annum for further 20 years. All lease payments are to be made yearly in advance. Assume that the effective rate of tax is 50% and taxes are when due. The company’s cost of capital is expected to be 7%, Which lease or buy should it choose?Page 2 of 2 CRED Grand Monarch Manufacturing Company can purchase a machine for Rs.20,000 or make four annual lease prepayments of Rs.6,000. The machine's life is 4 years with no residual value. The company pays tax « 52 per cent, approximately one year after earning its cash flows. A bank loan is available to finance the purchase @ 21 per cent. Should the company lease or borrow and buy, assuming that: (a) The company does not expect to pay corporation tax for the foreseeable future; (b) The company expects to pay corporation tax @ 52 per cent. Case: = Cases in Financial Management, I. M. Pandey (TMH) Case: Vishal Engineering ——Vishal Engineering Enterprises is amedium-sized engineer- ing company. It had total assets of £270 crore and sales of %256 crore in 1998. The company has been growing at an annual rate of 23 per cent during the last five years, and the Management expects to maintain this trend for the next couple of years. The growing operations of the company led the management to consider the possibility of acquiring a medium size, specially designed computer for its CAD/CAM functions. The management of the company, therefore, in- vited representatives of some leading computer firms tohelp them in designing a useful and cost-effective system. After an evaluation of various available alternatives, the company fixed up its mind on TECH 2005 computer, supplied by a leading computer manufacturing company, which would best meet its current and expected future needs. ‘The finance department evaluated the profitability of buying the TECH 2005 computer, using its normal capital budgeting procedures. The company has a policy of using 12 per cent after-tax cut-off rate for modernization, upgra- dation or automation Projects. For higher risk projects, @ higher cut-off rate is used. It was found that computer has a positive expected NPV. The chief finance manager has been recently reading@jot about leasing and hire purchase busines i epwidiaries of a number of banks Private firme na tHe manufactures have been offering lease and imo wel a8 finance. He thought that there should beens Purchase options. He therefore decided to talk to the men nthe? ofthe computer manufacturing company if they rant the computer on lease or hire purchase basic that the manufacturer was ready to cor computer on lease or hire purchase, The purchase price of the computer is 875 lakh, Ithas an expocted life of eight years. The company exper receive a pre-tax benofit of 818 lakh per year from the ruse of! computer. The company’s tax consultant had indicated thos ifthe computer is purchased, the company can deprecinns the computer on written down value basis at 25 per cone er annum, On the other hand, if the company decides ta take the computer on lease, it will have to forego tax boxe efton depreciation, The company will be requived to pay lease rentals of 214 lakh at the beginning of each year fo. eight years If Vishal Engineering Enterprises buys the ear, puter, it will be sorviced and maintained by the computer company for no extra cost, but in the case of lease, Vrshal Engineering Enterprises is expected to incur a maintenance cost of ebout 71.75 lakh per annum. The chief financial manager is not sure whether there would be any salvage value. However, he though that if the technology does not change drastically, it may be sold for % lakh. He knew that if the computer was taken on lease, he will have to forego the salvage value. He believed that the company’s after-tax cost of borrowing estimated to be 85 per cent is the appropriate rate to use, to evaluate the cash flows of leasing, The company's marginal tax rate is 35 per cent, Asregards the hire purchase option, the manufacturer quoted @ hire purchase instalment of €18.375 lakh per He found nsider supplying the Asset tPosed Financing: Lease, Hie Purchase and Project Financing 533 annum, payable in the beginning of the year. He had {alculated the annual instalment as shown in the table here, : Tlakh Cost of computer Bs Interest: 75 * 8 «12% ie 147, Annual instalment: 147/68 aa he finance manager was surprised to find a higher Quotation for the hire purchase instalment than the rental. But he did realize that under hire purchase. Company will be entitled to claim tax benefit on depr tion and receive salvage value. ‘Therefore, he thought it appropriate to systematically analyse the economics of both options, Discussion Questions 1. Determine cash flows under the lease. 2. Why does the chief financial manager believe that the company's aftertax borrowing rate is the appropri- ate discount rate for evaluating the lease alternative? Should he use this rate to discount the depreciation also? Why should he use WACC for discounting the salvage value? 3. Is leasing the computer attractive for Vishal? What is the net advantage of lease to the company? How much equivalent loan could the company borrow given the lease cash flows? 4. Whatis the effective rate of interest on hire purchase? Is the hire purchase better option for the company? Show calculations. Assume that the sum-of-years-digit method is used for allocating interest over the hire purchase period for tax purposes. $s Ma UNL Nentify an infrastructure project in your location (like Metro Train in Delhi or a toll bridge in Ahmedabad). Find out the financing arrangements for the project and critically evaluate those arrangements in terms of costs and risks.