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Pinnacle Academy
Solutions of Tests of
April 2015 Batch
201-202, Florence Classic, Besides Unnati Vidhyalay,
Jain Derasar Road, Ashapuri Society, Akota, Vadodara-20. ph: 98258 561 55
Solution of Test of
Leasing
[SFM – CA Final]
Conducted on 22nd August 2015
[Solution is at the end with marking for self-assessment]
Time Allowed-1 hour
Q1
Maximum Marks- 30
A mechanized feed spreader costs Rs.8,00,000. It has useful life of 5 years at the
end of which it has salvage value of Rs.1,00,000. The full cost of the asset shall be
written off over the useful life of 5 years and the same shall be admissible for tax.
Tax rate is 30%.
A lease arrangement calls for lease payments of Rs.1,90,000 in advance annually.
Alternatively, funds can be borrowed at 10% and loan repaid in equal annual
instalments in advance.
Using the IRR method, recommend the best alternative.
Q2
(10 Marks)
A customer of ABC Leasing company has expressed desire to acquire a machine on
lease on terms that lease rent shall be paid in the ratio of 3:2:1.
The sale value of the machine is Rs.600 lakhs and depreciation shall be charged by
following SLM.
If required return is 10% calculate lease rents for three years. Tax rate is 35%.
(10 Marks)
Q3
Pure Drinks is considering the acquisition of a machine to manufacture a new
flavored fruit pulp health drink. The cost of the machine is Rs.1,250 lakhs.
Pure Drinks can either outrightly buy the machine or acquire it on finance lease.
Bank is ready to provide 100% finance to Pure Drinks at an interest rate of
13.8462% and repayable in five equal annual installments payable at the end of
each year.
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The tax rate for the company is 35%.
The machine can also be acquired by paying in advance lease rent of Rs.350 lakhs
each year for five years. The useful life of the machine is five years at the end of
which it shall revert back to the lessor.
The machine shall have salvage value of Rs.10 lakhs at the end of 5th year. It shall
be depreciated by Pure Drinks following the straight line method.
You are required to calculate Net Advantage of Leasing (NAL) and recommend the
method of acquiring the machine. Cost of Capital is 12%.
(10 Marks)
th
(Assessed answer papers shall be returned latest by 12 September 2015)
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Solution of
Test of Leasing
Conducted on 22nd August 2015
Q1
Year
0
1-4
5
5
Determination of Post-tax cost of Leasing in % as per IRR Method:
Lease
Rent
Tax shield on
Lease DepreRent ciation
1,90,000
--------1,90,000 57,000 48,000
----57,000 48,000
Salvage Value foregone
(1,00,000 – 30%)
Addnl
Tax
Shield
On
Lease
Rent
----9,000
9,000
Net
Cash
Out
Flows
PVF
(10%)
PV
(10%)
PVF
(11%)
PV
(11%)
1,90,000
1,81,000
(9,000)
70,000
1.000
3.170
.621
.621
1,90,000
5,73,770
(5,589)
43,470
1.000
3.102
0.594
0.594
1,90,000
5,61,462
(5,346)
41,580
8,01,651
7,87,696
(7 marks)
NPV at 10% = 8,00,000 – 8,01,651 = (Rs.1,651)
NPV at 11% = 8,00,000 – 7,87,696 = Rs.12,304
Post-tax Cost of leasing = 10 + -1,651 / - 1,651 – 12,304 X 1 = 10.12 %
Post-tax Cost of borrowing = 10 (1 - .3) = 7%
(3 marks)
Recommendation: Borrowing alternative in view of lower cost.
Note:
Q2
Full cost is required to be written off.
Depreciation = 8,00,000 / 5 = Rs.1,60,000.
Salvage value available under borrowing alternative is foregone in leasing.
Hence, treated as opportunity cost after deducting STCG tax @ 30% as entire cost of
the asset has been written off.
Let lease rent be Rs. X in third year.
Calculation of PV from Lease Rent:
Year
1
2
3
Lease
Rent
3X
2X
X
Tax
(35%)
1.05X
0.7X
.35X
Net
Cash Inflow
1.95X
1.30X
0.65X
PVF
(10%)
.909
.826
.751
PV
1.7726X
1.0738X
0.4882X
3.3346X
(3 marks)
PV of total tax shield on depreciation =
=
=
(600 / 3) X 35 % X PVF (10%, 3)
70 X 2.487
Rs.174.09 lakhs
(3 marks)
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Total PV of cash flows from leasing =
3.3346X + 174.09
Lease rent should be so charged that cost of the asset should be recovered.
i.e. 600 = 3.3346X + 174.09 i.e. X = Rs.127.72 lakhs.
(3 marks)
Thus, lease rent in three years is Rs.383.16 lakhs, Rs.255.44 lakhs and Rs.127.72
lakhs.
(1 mark)
Q3
Discount rates used:
Lease Rent:
Tax shields and salvage value:
Pre-tax cost of debt i.e. 13.8462 %
WACC of lessee i.e. 12 %
Calculation of Net Advantage of Leasing (NAL):
Amount (Rs.)
Benefits of Leasing:
Cost of Machine Saved
PV of tax shield on lease rent paid (350 X 35% X 3.605*)
Leasing Benefits (A)
Costs of Leasing:
PV of Lease Rent Paid (350 X 3.923**)
PV of Depreciation foregone (248 X 35% X 3.605*)
PV of Salvage Value foregone (10 X 0.567***)
PV of tax shield on interest foregone (WN # 2)
Leasing Costs (B)
NAL (A – B)
1250.00
441.61
1691.61
1373.05
312.91
5.67
151.37
1843.00
(151.39)
* at 12% for 1 to 5 ** at 13.8462% for 0 to 4 *** at 12% for 5th
Working Notes:
(i) Equated Annual Installment = 1250 / 3.446 = 362.74 lakhs
(ii) PV of tax shield on interest foregone:
Year
1
2
3
4
5
Amount o/s
Interest
Tax Shield PVF
at beginning @ 13.8462%
@ 35%
(12%)
1250.00
173.08
60.58
.893
1060.34
146.82
51.39
.797
844.41
116.92
40.92
.712
598.59
82.88
29.00
.636
318.74
44.00
15.40
.567
PV
54.10
40.96
29.14
18.44
8.73
151.37
Recommendation: Machine should be purchased in view of negative NAL.
Solution prepared by
CA. Ashish Lalaji
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