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Financial evaluation of Leasing

Lessee’s View Point

Q.1 XYZ ltd is in business of manufacturing 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 salvage value of Rs.100000 after the expiry of 5 Years. The purchase can be
financed by 20% loan repayable in 5 equal installments becoming due at the end of each
year. Alternatively, the machine can be taken on year end lease rental of Rs.450000 for 5
years. Advise the company which option it should choose. For your exercise, you may
assume the following.

1. The machine will constitute a separate block for depreciation purpose. The
company follows written down value method of depreciation, the rate of
depreciation being 25%.
2. Tax Rate 35% and cost of capital is 18%
3. Lease rent are to be paid at the end of year

Annual Lease Rental

Q.2 The following details relate to an investment proposal of the Hypothetical Industries
Ltd (HIL)
Investment outlay, Rs 180 Lakh, Useful life,4 Years, Net Salvage Value after 3 years, Rs
18 Lakh, Annual Tax relevant rate of Depreciation,40%
The HLL has two alternatives to choose from to finance the Equipment:
Alternative I: Borrow and Buy the equipment. The cost of capital of HIL is = .12,
marginal rate of tax = .35, Cost of Debt = .75per annum.
Alternative II: Lease the equipment from Hypo Leasing Ltd on a 3 year full-payout
basis @444/Rs1000 payable annually in arrears. The lease can be renewed for a further
period of 3 years at a rental of Rs.18/1000 payable annually in arrear.
Which alternative should the HIL Choose? Why?

Monthly Lease Rental

Q.3 Taking data from question 2, assume the lease rental of Rs.35/1000 payable monthly
in advance. Compute the NAL/NPV(L).Should the HIL opt for lease financing?

Break even Lease Rental

Q4. Taking data from question 2, assume monthly lease payment in advance. Compute
the break even monthly lease rental. Can the HIL accept a lease quote of Rs. 35/1000 per
month payable in advance?
Lessor’s Viewpoint

Q.5 Taking data from Question 1, assume further that:1)the Lessor’s weighted average
cost of capital is 14%.Is it financially viable for leasing company to lease out the
machine?

Break- even lease Rental

Q.6 From the facts contained in Question 5, a) determine the minimum lease rentals at
which Lessor would break-even. Also prepare verification table. Determine the lease
rentals if the Lessor wants to earn NPV of Rs.1 lakh.

Q.7 The under mentioned facts relate to a lease proposal before the Hypo Leasing Ltd.:
The initial cost of equipment to be leased out is Rs 300 Lakhs, on which 10 % central
sales tax would be levied. At the end of the lease term after 5 years, the salvage value is
estimated to be Rs.33 Lakhs. The other cost associated with the lease proposal payable in
advance are initial direct cost = Rs.3 Lakhs and management fees=Rs 5 Lakhs. The
marginal cost of funds to the HLL is 14 % while the marginal rate of tax is 35%.What is
the breakeven rental for HLL if the tax relevant rate of depreciation is 25%.?

Q8.The HLL has under consideration a lease proposal. Its post-tax cost of fund is 14%
and it has to pay CST @ 10% of the basic price of the capital equipment in inter state
purchases. The marginal tax rate of HLL IS 35%, The details of the proposed lease are
given below:
• Primary Lease period 3 Years
• Tax relevant depreciation, 40% on written down value.
• Residual value,8% of the original cost
o If the monthly lease rentals are collected in advance, what is the minimum
lease rental HLL should charge for per Rs1000 for the lease?
o What is the minimum monthly lease rental for a lease proposal costing
Rs.660 Lakhs (Including 10% CST)

Negotiation of Lease rentals

Q9. Consider the following facts:

About the lessee (Hypothetical Industries Ltd:)

A) Tax relevant of Depreciation,40%


B) Useful life of an asset, 5 years
C) Estimated Salvage Value, Nil
D) Marginal cost if Debt,17%(Pre tax)
E) Marginal cost of capital,14%
F) Marginal tax rat,35%

About the Lessor (Hypothetical Leasing Ltd)


• Minimum Lease rental,Rs25/Rs.1000/Month, payable in advance
• Required minimum post tax return on lease portfolio,13%
i. What is break-even rental per Rs.1000 for Lessee and Lessor
ii. What is the 1) minimum lease rental of the lessee (2) the maximum
lease rental of the Lessor on an investment cost of Rs.210 Lakh?
The equipment can be assumed to be imported without any sales
tax implication.
iii. Assuming the equipment is indigenously available, the CST on
interstate sale of 4% for the lessee and 10% for the Lessor on the
basic price.
iv. Compute the monthly break even lease rental for the lessee and
Lessor?
Structuring of Lease Rentals

Q10. The pre tax cost of capital of the hypothetical Leasing Ltd. Is 20%.Its expected pre-
tax return on investment is 23%.Assuming a non-cancellable lease period of five years,
determine the lease rental per Rs.1000 so as to give to the HLL its expected income

Quarterly Rental

Q11.For the facts relating to HLL, in Question No.10, compute the quarterly rental to
earn a per tax return of 23%.

Advance Rental

Q12. For the facts in Question 10 assume the rental is paid in advance, that is in the
beginning of each year and compute the annual lease Rental.

Profile of Lease Rental

1. Stepped Rental
Q.13. The pre tax expected rate of return for the hypothetical leasing Ltd. is 24% for a
five year non- cancellable lease. The annual lease rental would be stepped at 10% over
the period. Compute the lease rental per Rs.1000.
2. Deferred Rental
Q.14 Considering the facts of Question 13, compute the lease rental as deferred for the
first two years.
3. Bell-Shaped Rental
Q15 Considering the facts of Question 13, the lease rental will be stepped by 25% and
then by 40% and subsequently stepped down in the reverse order in the fourth and the fist
year. compute the lease rental per 1000.

Lease rental at post tax Rate

The following facts relate to a lease proposal


Lease Period 5 Years
Depreciation 40%
Tax 50%
Pre tax expected rate of return 30%
Compute the lease rental payable in arrears per Rs.1000.

Comprehensive Leasing Questions


Q.1 The HML has under consideration investment in a project. The cost of the
equipment estimated to be Rs.900 Lakh plus 4% CST. The useful life of the
equipment is 5 years, with a salvage value of 40% of the book value after 5 years.
The depreciation relevant for tax purpose is 25%.The HML has other assets in this
block of 25%.The investment likely to generate an incremental earning before
depreciation, interest and tax of RS.720 Lakh per annum for the first 3 years and Rs
480 per annum for the last two years.
The HML has two alternatives to choose from to finance the equipment:
I: Leasing the equipment from the leasing company. The lease rental for 5 year non-
cancellable lease is Rs.27 (Per month per thousand) payable in arrears (at the end of
each year).The purchase of the equipment by the Leasing company is subject to a
CST of 10%
II: Borrow and Buy the equipment at 20% per annum. The Debt is repayable in 5
equated installments, Payable at the end of each year. The target debt equity ratio of
the HML is 2:1.Its cost of debt may be assumed to be 20% while the cost of equity is
22%.The marginal tax rate of HML is 35%.
You are required to compute the BELR for the Lessee. Should it buy or lease the
equipment?
Q.2 HCL ltd is considering acquiring an additional computer to supplement its time
share computer service to its client. It has two option
1. To purchase the computer for Rs.22,00,000
2. To lease the computer for 3 years from a leasing company for Rs.500000
annual lease rent plus 10% gross time share service revenue. The agreement
also requires an additional payment of Rs.600000 at the end of the third year.
Lease rent is payable at the year end and the computer reverts to the lessor
after the contract period.
The company estimates that the computer under review now will be worth Rs 10
Lakh at the end of third year,
Forecast Revenue are
Year 1 Rs,22,50,000
Year 2 Rs.25,00,000
Year 3 Rs.27,50,000
Annual operating cost (Excluding depreciation and Lease rent of computer ) are
estimated at RS.9,00,000 with an additional Rs.1,00,000 for start up and training
cost at the beginning of the first year. HCL ltd will borrow at 16 % interest to
finance the equipment, repayments are to be made according to the following
schedule.
Year End Principal Interest Total
1 5,00,000 352000 852000
2 850000 272000 1122000
3 850000 136000 986000

The company uses the straight line method of depreciation and pays 50% of tax.
The management of HCL approaches you for advice.