PROBLEM 4.

1
XYZ Ltd is in the 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 1,00,000 after the expiry of 5
years. The purchase can be financed by 20 per cent loan repayable in 5
equal annual installments (inclusive of interest) becoming due at the end
of each year. Alternatively , the machine can be take on year-end lease
rentals of Rs 4,50,000 for 5 years. Advise the company, which option is
should choose. For your exercise, you may assume the following.
i.

The machine will constitute a separate block for depreciation purposes.

The company follows written down value method of depreciation, the rate
of depreciation being 25 per cent.

ii. Tax rate is 35 per cent and cost of capital is 18 per cent.
iii. Lease rents are to be paid at the end of the year.
iv. Maintenance expenses estimated at Rs 30,000 per year are to be borne by
the lessee.
1

SOLUTION
PV of cash Outflows Under Leasing Alternative
Year-end

Lease rent After taxes

[R(1-t)]

1-5

PVIFA at

Total PV

13%

[Rs4,50,000(1-0.35)]

[20%(1-0.35)]

Rs 2,92,500

3.517

Rs 10.28 723

Borrowing/ buying Option

Equivalent annual loan installment = Rs 15,00,000/2.991(PVIFA for 5 years
at 20% i.e.; 20.5)= Rs 5,01,505

PV OF CASH OUTFLOWS UNDER BUYING ALTERNATIVE

Year

Loan

-end

Installment

2( Rs)

Tax advantage on
Interest

Depreciation

(I*0.35)

(D*0.35)

3 (Rs)

4 (Rs)

Net cash
Outflows
(col.2-col3+4)
5 (Rs)

PVIF
At

Total
PV

13%
6

7 ( Rs)

5,01,505

1,05,000

1,31,250

2,65,255

0.885 2,34,751
0.783 2,44,431

5,01,505

90,895

98,895

3,12,173

5,01,505

73,968

73,828

3,53,709

5,01,505

53,656

55,371

3,92,478

0.693 2,45,120
0.613 2,40,589

5,01,505

29,114

41,528

4,30,863

0.543 2,33,959
11,98,850

Less:1 PV of Salvage value (Rs 1,00,000X0.543)

54,300

2 PV of Tax savings on short term capital loss

1,02,945
3
NPV OF CASH OUTFLOWS 10,95,905

(Rs 3,55,958-Rs1,00,000)X0.35=(Rs 89,585X0.543)

48,645

WORKING NOTES
SCHEDULE OF DEBT PAYMENT
Payments
Year
Loan
at
the
Loan
Begging of
-end
Interest
Principal
Installment the Year
Col 3X0.20
repayment
1

2( Rs)

3 (Rs)

4 (Rs)

5 (Rs)

Loan outstanding
At he end of the
year
col 3-col5
7 ( Rs)

5,01,505

15,00,000

3,00,000

2,01,505

12,98.495

5,01,505

12,98,495

2,59,699

2,41,806

10,56,689

5,01,505

10,56,689

2,11,338

2,90,167

7,66,522

5,01,505

7,66,522

1,53,304

3,48,201

4,18,321

5,01,505

4,18,321

83,184*

4,18,321

-----

* Difference between loan installment & loan outstanding

SCHEDULE OF DEPRECIATION
Year

Depreciation (Rs)

Balance at the end of the Year (Rs)

15,00,000 X 0.25 = 3,75,000

11,25,000

11,25,000 X 0.25 = 2,81,250

8,43,750

8,43,750X 0.25 = 2,10,937

6,32,813

6,32,813 X 0.25 = 1,58,203

4,74,610

4,74,610X 0.25 = 1,18,652

3,55,958

The company is advised to go for

leasing as the PV of Cash Outflow under leasing option is
lower than under/barrowing alternative
RECOMMENDATION: