What is lease?

A lease represents a contractual arrangement whereby the lessor

grants the lessee the right to use an asset in return for periodical lease
rental payments.

Types of leases:

Based on variations, the following classifications have evolved:

1. Finance lease vs. operating lease

2. Sale and leaseback vs. direct lease

3. Single investor lease vs. leveraged lease

4. Domestic lease vs. international lease

The descriptions of these are following:

1. Finance lease vs. operating lease: A finance lease or capital lease is essentially a form of borrowing.
Its salient features are:

a. It is an intermediate term to long term non cancellable arrangement. During the initial lease period,
referred to as the “primary lease period”, which is usually 3 years or 5 years or 8 years, the lease cannot
be cancelled. Primary Lease Term means the initial term of this Lease commencing on the
Commencement Date and ending on the Expiration Date. When the 'Primary Period' is due to end, there
may be an option to extend the lease by entering into a 'Secondary Hire' period.
b. The lease is more or less fully amortized during the primary lease period. This means that during this
period, the lessor recovers, through the lease rentals, his investment in the equipment along with an
acceptable rate of return.

c. The lessee is responsible for maintenance, insurance and taxes.

d. The lessee usually enjoys the option for renewing the lease for further periods at substantially
reduced lease rentals.

An operating lease can be defined as any lease other than a finance lease. The salient features of an
operating lease are:

a. The lease term is significantly less than the economic life of the equipment.

b. The lessee enjoys the right to terminate the lease at short notice without any significant penalty.

c. The lessor usually provides the operating know-how and the related services and undertakes the
responsibility of insuring and maintaining the equipment. Such an operating lease is called a “wet lease”.
An operating lease where the lessee bears the costs of insuring and maintaining the leased equipment is
called a “dry lease”.

2. Sale and lease back vs. direct lease: Under a sale and lease back, a firm that owns land, building or
equipment sells the property & simultaneously executes an agreement to lease the property back for a
specified period under specific terms.

A direct lease can be defined as any lease transaction which is not a “sale and lease back” transaction. In
other words, in a direct lease, the lessee and the owner are two different entities. A direct lease can be
of two types: bipartite lease and tripartite lease. In a bipartite lease, there are two parties to the
transaction- the equipment supplier cum lessor and the lessee. A tripartite lease, on the other hand, is a
transaction involving three different parties-the equipment supplier, the lessor, and the lessee.

3. Single investor lease vs. leveraged lease: In a single investor lease transaction, the leasing company
(lessor) funds the entire investment by raising an appropriate mix of debt and equity. The important
point to be noted is that the debt funds raised by the leasing company are without recourse to the
lessee. Put differently, the lender cannot demand payment from the lessee in the event of the leasing
company defaulting on its debt servicing obligations.

In a leveraged lease transaction, the leasing company (called the equity participant) and a lender (called
the loan participant) jointly fund the investment in the asset to be leased to the lessee. Each lease rental
received from the lessee is bifurcated into two parts: a part which represents the debt service charge on
the loan that is passed on to the loan participant; and the balance one which is passed on to the lessor.

4. Domestic lease vs. international lease: A lease transaction is classified as a domestic lease if all
parties to the lease transaction-the equipment supplier, the lessor, and the lessee-are domiciled in the
same country. A lease transaction is classified as an international lease if one or more of the parties to
the transaction are domiciled in different countries.
Rationale for Leasing: A variety of reasons are cited in support of leasing. Some of them are plausible
while others are dubious.

(I) Plausible reasons:

(a) Convenience: Suppose you want a car for one month. You can buy one and sell it after a month.
Doing so, however, will involve a lot of effort, time and cost. You have to select one, arrange to its
financing, and negotiate its resale after your use. You have the simple alternative of renting the car for a
month. Likewise, when a company needs equipment for a short period, it makes sense to lease it, rather
than buy it. Of course, such a lease will invariably be an operating lease.

(b) Benefits of Standardization: Suppose you run a finance company that specialized in leasing trucks.
You are effectively lending money to a number of firms that may vary in size and risk. Since the asset in
each case is the same (a truck), you can use a standardized contract and you don’t have to incur large
administrative and investigative costs. Put differently, standardization and economies of scale will
reduce administration and transaction costs. Due to these benefits, leasing can be a cheaper source of
finance, particularly for smaller companies.

(c) Better utilization of tax shields: Leasing may be a tax beneficial arrangement. A firm that cannot, on
its own, avail of tax benefits of owning an asset may share a part of that benefit in the form of lower
lease rentals by taking the asset on lease from a firm that enjoys tax benefit in full.

(d) Fewer restrictions covenants: Term loans have several restrictive covenants associated with them.
These relate to matters like new investments, additional financing, working capital position, managerial
appointments, dividend payment, and provision of guarantees. By comparison lease contracts contain
fewer and less restrictive covenants.

(e) Lower cost of obsolescence risk: In an operating lease, the lessee can terminate the lease at will.
This means that the risk of obsolescence is borne by the lessor. The lessor, however, enhances the lease
rental suitably for bearing the risk of obsolescence. In effect, the lessee bears the cost of obsolescence
risk. Is it possible for a user of asset to reduce the economic cost of obsolescence by way of leasing? Yes,
this may happen. The lessor, with better access to potential users of assets, may be able to find a more
economic use for somewhat obsolescent assets and thereby reduce the economic cost of obsolescence.

(f) Expeditious implementation: If debt financing is sought from lending institutions, the process of
project preparation, appraisal and sanction can be somewhat time consuming. It may take one to three
months and sometimes even longer. As against this, lease financing can be tied up quickly. It can be
finalized within few days. Hence, leasing facilitates expeditious implementation of a project.

(g) Matching of lease rentals to cash flow capabilities: As against term loan, leasing companies claim
that they can tailor make lease rentals to match the cash flow capability of the lessee.

(II) Dubious reasons for leasing:

(a) Hundred percent financing: Leasing companies often claim that they provide “100% financing”
because they pay the entire cost of the leased asset. Hence they argue that leasing preserves
the capital of the lessee firm.
(b) Circumvention of certain controls: In some organizations, leasing decisions are considered as
operating decisions and not capital budgeting decisions. This may induce managers to resort to
leasing so that they can circumvent (a way of avoiding difficulty) the rigorous approval
procedure required for capital budgeting.
(c) Favorable financial ratios: Traditionally, leases (both operating & financial) have been regarded
as off balance sheet sources of finance. This means that the leased asset and the liability
associated with it are not shown on the balance sheet of the lessee firm. Thanks to such a
treatment, leasing improves the debt equity ratio of the firm.
 Hire purchase: It is a method of financing of the fixed asset to be purchased on future date.
Under this method of financing, the purchase price is paid in installments. Ownership of the
asset is transferred after the payment of the last installment.

A summary of tabular presentation of differences between lease and hire purchase:

Hirer/buyer
Hiree/seller
Difference between Hire Purchase vs. Term Loan
In Easier Terms: Should I hire or Should I buy?

1. Ownership: In hire purchase, the seller/financier owns the asset until the buyer makes
the final payment and hence the word “Hire” is used. Whereas in the term loan, the
buyer borrows money, pays for the asset, and own it immediately. So, in the case of hire
purchase, one cannot sell the asset if he runs into problems making periodic payments
but in the term loan, it can be sold.
2. Cost of the asset: The cost of the asset in case of the term loan is the cost at which the
buyer purchases + installation cost if any, whereas, in the case of hire purchase, the cost
to the buyer is normal cash price + HP Interest. The interest cost is incurred in case of
term loan also but that forms part of finance cost of the company and is not capitalized
with the asset.

3. REPOSSESSION OF THE HIRED ASSET: It may happen that the buyer is unable to pay all
the payments required under the agreement. Once the buyer stops making the
installments, the seller/financier has the right to take away the asset. This is called
Repossession. In term loan, the borrower can only take away the assets which are
provided as security against the loan. Normally, the purchased asset is the primary
security of the term loan along with the collateral security. So, the bank or financial
institution can take away the underlying asset as well as the collaterals.

4. MORTGAGE OF ASSETS IN THE FORM OF SECURITY: No security, in any form, is required

for taking an asset on hire. Whereas the borrowers need to pledge his assets as security
in case of the term loan.

5. FINANCIAL STATEMENTS: In hire purchase, the value of the asset is not included in the
financial statements since the owner is the financier company till the buyer pays the last
hire charges installment. Whereas in the case of a loan, the value of asset appear on the
asset side and a corresponding liability for loans against such asset appear on the
liability side.

6. EFFECT OF TAXATION: In both the cases, i.e. when the asset is purchased by loan, or if it
is taken on hire, the user of the asset can take deduction on the depreciation of the
asset (which decrease every year due to written down value effect) and also for interest
on term loan or hire purchase installments. The only difference being in the quantitative
amount of interest.

7. CASH FLOW Since there is no purchase of an asset in hire purchase, the cash flow is
limited up to the hire purchase installments. Whereas in a case of the term loan, the
cash flow includes down-payment, loan received, purchase of asset and installment paid
at the required time.
Lease or Buy Decision:

Lease or buy decision involves applying capital budgeting principles to determine if leasing as
asset is a better option than buying it.

Leasing in a contractual arrangement in which a company (the lessee) obtains an asset from
another company (the lessor) against periodic payments of lease rentals. It may typically also
involve an option to transfer the ownership of the asset to the lessee at the end of the lease.

Buying the asset involves purchase of the asset with company’s own funds or arranging a loan
to finance the purchase.

In finding out whether leasing is better than buying, we need to find out the periodic cash flows
under both the options and discount them using the after-tax cost of debt to see where does
the present value of the cost of leasing stands as compared to the present value of the cost of
buying. The alternative with lower present value of cash outflows is selected.

After-tax cash flows of lease

Determining periodic cash flows in case of leasing is easy. Most leases involve periodic fixed
payments and an optional one-time terminal payment. They may also involve payment of
insurance, etc. associated with the asset which also needs to be accounted for. These payments
have associated tax shield, i.e. they are allowed as deduction from the company’s taxable
income which results in a decrease in net tax liability of the company.

Periodic after-tax cash flows of lease = (maintenance costs + lease rentals) * (1 – tax rate)

Terminal after-tax cash flows = periodic after-tax cash flows + amount paid at purchase the
asset

After-tax cash flows of purchase

The most significant component of cash outflows in case of purchase of asset is the payment
for cost of the asset. If the company uses its own funds, the total cost is assumed to be paid at the
time 0, however, if the company obtains a loan to finance the purchase, the loan repayment and
associated tax shield on interest shall appear in all the periods of the lease analysis.

Other cash flows include the tax shield on depreciation, any potential savings, maintenances costs,
insurance, etc. associated with the purchase and use of the asset.
Once we know the after-tax cash flows under both the alternatives, we just need to find present values
for each option using the company’s after-tax cost of debt and choosing the option that has lower
present value of cash outflows.

Example

B-Tel, Inc. is a telecommunication services provider looking to expand to a new territory Z; it is analyzing
whether it should install its own telecom towers or lease them out from a prominent tower-sharing
company T-share, Inc.

Leasing out 100 towers would involve payment of $5,000,000 per year for 5 years.

Erecting 100 news towers would cost $18,000,000 including the cost of equipment and installation, etc.
The company has to obtain a long-term secured loan of $18 million at 5% per annum.

Owning a tower has some associated maintenance costs such as security, power and fueling, which
amounts to $10,000 per annum per tower.

The company’s tax rate is 40% while its long-term weighted average cost of debt is 6%. The tax laws
allow straight-line depreciation for 5 years.

Determine whether the company should erect its own towers or lease them out.

Solution

Annual cash out flows of leasing (Year 1 to Year 5) = $5,000,000 * (1 – 40%) = $3,000,000

Annual cash flows of purchasing have three components: the loan amount to be repaid in each period,
the maintenance costs to be borne each year, the tax shields associated with maintenance costs,
depreciation expense and interest expense. The following table summarizes the calculation of cash flows
under this alternative.

Period 1 2 3 4 5
Loan repayment A 4,157,546 4,157,546 4,157,546 4,157,546 4,157,546
Maintenance costs B 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000
Depreciation D 3,600,000 3,600,000 3,600,000 3,600,000 3,600,000
Interest expense I 900,000 737,123 566,101 386,529 197,978
Total tax deductions T = B+D+I 5,500,000 5,337,123 5,166,101 4,986,529 4,797,978
Tax shield @ 40% t = 0.4×T 2,200,000 2,134,849 2,066,441 1,994,612 1,919,191
Net cash flows N = A+B–t 2,957,546 3,022,697 3,091,106 3,162,935 3,238,355
Annual loan repayment is based on present value calculation; it is the amount paid at the end of each
year for 5 years that would write off the loan completely. It is calculated using the following MS Excel
function: PMT (5%, 5,-18000000).

Interest expense is calculated in the following debt amortization table:

Opening Total Principal Closing

Period Interest
Principal Repayment Repayment Principal
0 18,000,000 - - - 18,000,000
1 18,000,000 4,157,546 900,000 3,257,546 14,742,454
2 14,742,454 4,157,546 737,123 3,420,424 11,322,030
3 11,322,030 4,157,546 566,101 3,591,445 7,730,585
4 7,730,585 4,157,546 386,529 3,771,017 3,959,568
5 3,959,568 4,157,546 197,978 3,959,568 -
It is necessary to prepare amortization table because tax laws do not allow deduction of total loan
amount, instead only interest expense is allowed as deduction.

Depreciation is calculated on straight-line basis using the 5-year useful life (i.e. $18,000,000/5 =
$3,600,000).

Tax shield is subtracted from loan repayments and maintenance costs while calculating the net cash
outflows because tax shield represents a cash inflow which arises due to tax deductibility of the
expenses.

Now, we have to calculate the present value of cash outflows under both the options using the after-tax
cost of debt which is 3.6% (6% * (1-40%))

Present value of leasing at 3.6% = $13,545,157

Present value of purchasing at 3.6% = $13,950,176

Since leasing has a lower present value of cash outflows, it should be the preferred option.
Question no: 1

You are given with the following information:

Cost of the equipment = Tk.20000

Lease term = 3 years (Monthly in arrear)

Implied interest rate = 18.5%

Requirement: a) Calculate the monthly lease rent if it is paid at the end of the month.

b) If it is paid at the beginning of the month.

c) If the payment is made in 3 monthly advances then what is the monthly payment?

d) Calculate effective annual rate.

a) PVAn=C×PVIFAk,n

C= PVAn /PVIFAk,n

Monthly lease rental (at the end of the month) =

PV
A
1– (1+k/m)-nm
Where, A=
K/m

0.185
K/m = =0.015417
12

1– (1+0.015417)-36
A=
0.015417

= 27.46957241

Monthly rent in arrear = 20000

27.46957241
= Tk. 728.07

b) Monthly lease rental (at the beginning of the month) = PV

A
1– (1+K/m)-nm
Where, A= (1+k/m)
K/m

0.185
K/m = =0.015417
12
 1– (1+0.015417)-36
A= (1+ 0.015417)
0.015417

= 27.89307081

Monthly rent at the beginning of the month = 20000

27.89307081
= Tk. 717.0239568

c) Monthly lease rental (3 monthly advance) = PV

A
1– (1+k/m)-(mn-3)
Where, A= +3
k/m

0.185
k/m = =0.015417
12

1– (1+0.015417)-(36-3)
A= +3
0.015417

= 28.7132668

Monthly rent 3 monthly advance = 20000

28.7132668
=Tk. 696.5421

d) Effective annual rate EAR= (1+k/m)m-1

= (1+0.185/12)12 - 1

= 0.2015 = 20.15%

Question no: 2

Cost of the machine= Tk. 20000

Period = 3 years

Installment (arrear) monthly = Tk. 728

No of installment = 36

True rate=?

PVAn=C×PVIFAk,n
C×PVIFAk%,n=PVAn

PVIFAk%,n=PVAn/C

PVIFA k%, 36 = 20000

728

= 27.4725

From PVIFA table, it lies in between 18% and 19%:

At 18%, PVIFA = 27.6606

At 19%, PVIFA = 27.2806

1– (1+0.18/12)-36
A=
0.18/12

1– (1+0.015)-36
=
0.015

=27.6606

True rate,

PVIFA at A –True PV factor

=A+ × (B-A)

PVIFA at A – PVIFA at B

27.6606 –27.4725

=0.18+ × (0.19-0.18)

27.6606 – 27.2806

= 18.495%

Alternatively,

True PV factor- PVIFA at B

B- × (B-A)

PVIFA at A – PVIFA at B

27.4725 –27.2806
=0.19 - × (0.19-0.18)

27.6606 – 27.2806

Question #3 Let us take an example of John, who is planning to buy a car on lease. The lease will be for a
period of 36 months & value of machine is TK. 3, 00,000. And monthly lease rent is Tk.10, 825. What is
the true rate of lease?

PVIFA k%, 36 = 300000

10825

= 27.713625

From PVIFA table, the value lies in between 17% and 18%.

At 17%, PVIFA = 28.048345

At 18%, PVIFA = 27.660684

PVIFA at A –True PV factor

=A+ × (B-A)

PVIFA at A – PVIFA at B

28.048345 –27.713625

=0.17+ × (0.18-0.17)

28.048345 – 27.660684

=0.1786=17.86%

True PV factor- PVIFA at B

B- × (B-A)

PVIFA at A – PVIFA at B

27.713625- 27.660684

0.18- × (0.18-0.17)

28.048345 – 27.660684
Question no: 3

Cost= Tk. 20000

Residual value= Tk. 2000

Lease term= 3 years (monthly in arrear)

Nominal lease rate=18.5%

Determine the monthly lease rental in arrears.

Solution:

Present value of residual value: =2000

(1+.185/12)36

=2000 ×(1+0.185/12)-36

=Tk. 1153.01683

Amount to be amortized= 20000-1153.02

= Tk. 18846.98

PV

Monthly rental in arrear=

1– (1+K/m)-nm
Where, A=
K/m

=27.46972442

18846.98

Monthly rental in arrear=

27.46972442

= Tk. 686

PVAn=C×PVIFAi,n ordinary annuity

PVAn=C×PVIFAi,n×(1+i) Annuity due

Question-4:

Lease cost= Tk. 10, 00,000

Lease rate (true rate) =10%
Lease term= 3 years (Quarterly Payment)
Amortization schedule=?

Solution:

Total no of rental payment=3×4=12

Lease rental= PV
A
1– (1+K/m)-nm
Where, A=
K/m

1-(1+0.10/4)-12
=
0.10/4

=10.2577646

=10, 00,000/10.2577646

=Tk. 97,487

Amortization Schedule:

Quarter Lease rent Variable charge Fixed charge Amount to be

amortized
0 10,00,000
1 97487 25000 72487 927513
2 97487 23188 74299 853214
3 97487 21330 76157 777057
4 97487 19426 78061 698996
5 97487 17475 80012 618984
6 97487 15474 82013 536971
7 97487 13424 84063 452908
8 97487 11325 86164 366744
9 97487 9168 88319 278425
10 97487 6961 90526 187899
11 97487 4697 92790 95109
12 97487 2378 95109 Nil
Question-5

From the following particulars of a lease agreement calculate the amount of lease rental to be
recovered by the lessor during the primary lease period.

a) Cost of the equipment to be leased Tk.800000

b) Lease management fee-2% of the cost
c) Primary lease period-5 years
d) Secondary lease period-3 years
e) Secondary period lease rental Tk.1000 per annum paid in advance
f) Transfer price-1% of the equipment cost
g) Capital structure-(i) equity 30% & cost of equity 20% (ii) Debt 70% & cost of debt 17%
1
h) Depreciation rate 33 3 % or 100/3=33.3333% =0.3333
i) Tax rate of lessor 50%

Solution:

Determining the primary period lease rental

tp t t
∑
Ct –LMF= LRp (1-T) + ∑ LRs (1-T) + ∑ D1 T + TPn
n=1 (1+K)n r
t=tp+1 (1+K)n n=1 (1+K)n (1+K)n

Year Depreciation(D) Written down Depreciation Present value PV of

33.3333% value tax shield D×T factor1/(1+k)n depreciation
0 800000
1 266667 533333 133334 0.89286 119049
2 177778 355555 88889 0.79719 70861
3 118518 237037 59259 0.71178 42179
4 79012 158025 39506 0.63552 25107
5 52675 105350 26337 0.56743 14945
6 35117 70233 17558 0.50663 8896
7 23411 46822 11705 0.45235 5295
8 15607 31215 7803 0.40388 3152
PV of depreciation tax shield= 289484

Weighted average cost of capital (k)= Weke + wdkd (1-T)

=0.30×0.2+0.7×0.17 (1-0.5)

=11.95% or 12%

Present value of secondary lease rental:

= 1000 (1-0.5) + 1000(1-0.5) + 1000(1-0.5)

(1+0.12)5 (1+0.12)6 (1+0.12)7
=763

Transfer price= Cost×1%

=800000×0.01

=8000

Present value of transfer price= 8000

(1+0.12)8

=3231

Lease management fee=2% of the cost

=0.02×800000

=16000

After tax= 16000 × (1-0.5)

=8000

5
800000-8000 = ∑
LRp (1-T) + 763+289484+3231
5 n=1 (1+K)n

792000 = ∑
LRp (1-T) + 293478
5 n=1 (1+K)n

∑ LR (1-T) =498522
p

n=1 (1+K)n

LRp(1-T)=498522/PVIFA12%,5

LRp(1-T)=498522/3.60477

LRp(1-0.5)=138294.8544

LRp=138294.8544/0.5

LRp=276590

Question-6

From the following information of lease rental agreement calculate lease rent that should be charged in
the primary lease period to reach to the breakeven point.

Necessary information: i) Cost of the equipment to be leased Tk. 14, 00,000 ii) Lease management fee
3% of cost iii) Primary lease period 6 years iv) Secondary lease period 7 through 10 years v) Lease rent
for secondary period paid in advance Tk. 1500 vi) transfer price 2% of the equipment cost vii)
Depreciation 20% (declining method) viii) Tax rate of lessor 35% X) Capital structure-(a) equity 60% and
cost of equity 18% (b) Debt 40% and cost of debt 15% pretax.

1. A company has considered acquiring a machine costing of Tk. 154000. The company can take lease
from industrial development company (IDLC) for 7 years. The annual lease agreement is Tk. 28000 per
year to be paid in the beginning of the year. It has another alternative to take loan from Rupali Bank
LTD. at 12% interest rate per year repayable in the beginning of the year to buy the machine. The life of
the asset will be 7 years with no salvage value. The company is in 40% tax bracket. Which alternative
should the company choose to finance the machine?

Assume after tax cost of capital is 8%.

Depreciation is charged on straight line method.

Solution:

Tax rate=40%

Tax shield on lease payment=28000×0.4=11200 per annum.

Year Gross payment Tax advantage Net Payment

0 28000 - 28000
1-6 28000 11200 16800
7 - 11200 (11200)

Present value of net outflow under leasing:

=28000+16800×PVIFA8%, 6 -11200×PVIF8%.7

=28000+16800×4.622879664-11200×0.583490395

1-(1+K)-n
PVIFA =
K

-n
PVIF=(1+K)

=28000+16800×PVIF+16800×PVIF+16800×PVIF+16800×PVIF+16800×PVIF+16800×PVIF-11200× PVIF8%.7
-1 -2 -3 -4 -5 -6 -7
=28000+16800×(1+.08) + 16800×(1+.08) + 16800×(1+.08) + 16800×(1+.08) + 16800×(1+.08) + 16800×(1+.08) -11200×(1+.08)

=99130

Evaluating Buying alternatives:

PVAn=C×PVIFAk,n

Total borrowing=154000

Loan Payment (Due) = 154000

PVIFA12%, 7(due)

= 154000
 4.5637×1.12

=30130

Amortization= 154000

=22000

Year Loan payment Interest (12%) Principal Remaining

obligation
0 30130 --- 30130 123870
1 30130 14864 15266 108604
2 30130 13032 17098 91506
3 30130 10981 19149 72357
4 30130 8683 21447 50910
5 30130 6109 24021 26889
6 30130 3227 26903 ---

Schedule showing net cash outflow under Buying:

Year Loan Interest Dep. Int+Dep Tax adv. Net cash

payment (12%) 5×40% adv.(2-6)
0 30130 --- --- --- --- 30130
1 30130 14864 22000 36864 14746 15384
2 30130 13032 22000 35032 14012 16118
3 30130 10981 22000 32981 13192 16938
4 30130 8683 22000 30683 12273 17857
5 30130 6109 22000 28109 11244 18886
6 30130 3241 22000 25241 10096 20036
7 --- --- 22000 22000 8800 (8800)

Present value of net cash outflow:

=30130+15384×(1.08)-1+16118×(1.08)-2+16938×(1.08)-3+17857×(1.08)-4+18886×(1.08)-5+20036×(1.08)-6-
8800×(1.08)-7

=105108

Thus PV of cash outflow under leasing Tk.99130

PV of cash outflow under borrowing Tk. 105108

Since the present value of cash outflow under leasing is below that of debt financing i.e. the company
should go for lease financing.

If a company acquired a machine costing Tk.350, 000 by taking loan from UCB Ltd at 14% interest rate
per year repayable in the beginning of the year to buy the machine. The life of machine is 7 years with
no salvage value. You have to compute the present value of net cash flow under buying? Also consider
after tax cost of capital is 10% and depreciation is charged on straight line method. And also the
company is in 35% tax bracket. It has another alternative to acquire the machine by leasing from IDLC
for 7 years. The lease agreement is tk. 45,000 per year to be paid in the beginning of the year. Which
alternative should the company choose to finance the machine using incremental approach?

Incremental Approach: 4 steps for evaluation:

1. Determine the net cash flow under each alternative.

2. Determine the incremental cash flow for lease or buy.
3. Determine the present value of incremental cash flow at given opportunity cost.
4. Take the decision.
Year Lease Buy Incremental cash flow
(Lease-Buy)
0 28000 30130 (2130)
1 16800 15384 1416
2 16800 16118 682
3 16800 16938 (138)
4 16800 17857 (1057)
5 16800 18886 (2086)
6 16800 20036 (3236)
7 (11200) (8800) (2400)

If opportunity cost is 8% in that case, the present value of incremental cash flow will be,

=-2130+1416×(1+.08)-1+682×(1+0.08)-2-138×(1+0.08)-3-1057×(1+0.08)-4-2086×(1.08)-5-3236×(1.08)-6-
2400×(1.08)-7

=-5979.96

As present value of incremental cash flow of lease minus buy is negative, it indicates that lease
alternative associate with lower cost. So in this circumstance one should go for lease financing.

Question: If a company acquired a machine costing Tk.350, 000 by taking loan from UCB Ltd at 14%
interest rate per year repayable in the beginning of the year to buy the machine. The life of machine is 7
years with no salvage value. You have to compute the present value of net cash flow under buying? Also
consider after tax cost of capital is 10% and depreciation is charged on straight line method. And also
the company is in 35% tax bracket. It has another alternative to acquire the machine by leasing from
IDLC for 7 years. The lease agreement is tk. 45,000 per year to be paid in the beginning of the year.
Which alternative should the company choose to finance the machine using incremental approach?

Solution:

Tax rate is 35%

Tax shield on lease payment=45,000×0.35=15,750 per year

Year Gross payment Tax advantage Net payment

0 45,000 -------- 45,000
1-6 45,000 15,750 29,250
7 ----- 15,750 (15,750)
Present value of net cash outflow under leasing:
=45000+ 29250×PVIFA10%,6-15750×PVIF10%,7

=45000+29250×4.355260699-15750×0.513158118

=164309.1351

Evaluating Buying alternatives:

PVAn=C×PVIFAk,n

Total borrowing(PVAn)=350000

Loan Payment (Due) = 350000

PVIFA14%, 7(due)

= 350000

4.288×1.14

=71599

Amortization= 350000

=50000

Year Loan payment Interest (14%) Principal Remaining

obligation
0 71599 ----- 71599 278401
1 71599 38976 32623 245778
2 71599 34409 37190 208588
3 71599 29202 42397 166191
4 71599 23267 48332 117859
5 71599 16500 55099 62760
6 71599 8786 62813 -----

Schedule showing net cash outflow under Buying:

Year Loan Interest Dep. Int+Dep Tax adv. Net cash

payment (12%) 5×35% adv.(2-6)
0 71599 --- --- --- --- 71599
1 71599 38976 50000 88976 31142 42457
2 71599 34409 50000 84409 29543 42056
3 71599 29202 50000 79202 27721 43878
4 71599 23267 50000 73267 25643 45956
5 71599 16500 50000 66500 23275 48324
6 71599 8786 50000 58786 20575 51024
7 --- --- 50000 50000 17500 (17500)
PV of cash outflow under buying:
=71599+42457×(1.10)-1+42056×(1.10)-2+43878×(1.10)-3+45956×(1.10)-4+48324×(1.10)-5+51024×(1.10)-6-
17500×(1.10)-7

=259135

Year Lease Buy Incremental cash flow

(Lease-Buy)
0 45000 71599 -26599
1 29250 42457 -13207
2 29250 42056 -12806
3 29250 43878 -14628
4 29250 45956 -16706
5 29250 48324 -19074
6 29250 51024 -21774
7 (15750) (17500) 1750

The PV of cash outflow under leasing is Tk.164309

The PV of cash outflow under buying is tk. 259135

Using after tax cost of capital 10% we get,

=-26599-13207× (1.10)-1-12806× (1.10)-2-14628× (1.10)-3-16706× (1.10)-4-19074× (1.10)-5-21774× (1.10)-

6+1750× (1.10)-7

=-94824

As present value of incremental cash outflow of lease minus buy is negative, it indicates that lease
associate with lower cost. Hence in this circumstance one should go for lease financing.

Assume that Buehner corporation Ieases equipment from Universal leasing Company with the following
terms:

Lease period: Five years. beginning January. 1, 1984. Noncancelable.

Rental amount: $43,000 per year payable in advance; includes $3000 to cover executory costs to be paid
by lessor.

Estimated economic life of equipment: Five years.

Expected residual value of equipment at end of lease period: None.

Assuming that Buehner corporation’s incremental borrowing rate is 8%.

The present value of lease is,

=40000×PVIFA8%,5×(1+0.08)

=40000×3.992710037×1.08

=172485.07=172485
Schedule of lease payment:

Date Description Amount Interest Principal Lease

expense (8%) obligation
1.1.1984 Initial Balance ------ ------- ------- 172485
1.1.1984 Receipt/Payment 40,000 ---- 40,000 132485
31.12.1984 -do- 40,000 10599 29401 103084
31.12.1985 -Do- 40,000 8247 31753 71,331
31.12.1986 D0 40,000 5706 34294 37,037
31.12.1987 D0 40,000 2963 37037 --------

To simplify the schedule, it is assumed that the subsequent payment after the first payment is made at
the end of previous year/ lease payments after the first payment are made on December 31 of each
year.

Journal entries in the books of Lessee:

Date Particulars Tk. TK.

1.1.1984 Leased equipment under capital leases-----Dr 172485
Obligations under capital lease -------Cr. 172485
1.1.1984 Lease expense (executory cost)----------------Dr 3000
Obligations under capital leases--------------Dr. 40000
Cash A/C-----------------------------------Cr. 43000
31.12.1984 Amortization expense on leased equipment ------Dr. 34497
Accumulated amortization on lease equipment u.c.l--Cr 34497
31.12.1984 Prepaid lease expense(executory cost)------------------Dr. 3000
Obligations under capital leases---------------------------Dr. 29401
Interest expense------------------------------------------------Dr. 10599
Cash A/C-------------------------------------Cr. 43000
31.12.1985 Amortization expense on leased equipment ------Dr. 34497
Accumulated amortization on lease equipment u.c.l--Cr 34497
31.12.1985 Prepaid lease expense(executory cost)------------------Dr. 3000
Obligations under capital leases---------------------------Dr. 31753
Interest expense------------------------------------------------Dr. 8247
Cash A/C-------------------------------------Cr. 43000
31.12.1986 Amortization expense on leased equipment ------Dr. 34497
Accumulated amortization on lease equipment u.c.l--Cr 34497
31.12.1986 Prepaid lease expense(executory cost)------------------Dr. 3000
Obligations under capital leases---------------------------Dr. 34,294
Interest expense------------------------------------------------Dr. 5706
Cash A/C-------------------------------------Cr. 43000
31.12.1987 Amortization expense on leased equipment ------Dr. 34497
Accumulated amortization on lease equipment u.c.l--Cr 34497
31.12.1987 Prepaid lease expense(executory cost)------------------Dr. 3000
Obligations under capital leases---------------------------Dr. 37,037
Interest expense------------------------------------------------Dr. 2963
Cash A/C-------------------------------------Cr. 43000
31.12.1988 Amortization expense on leased equipment ------Dr. 34497
Accumulated amortization on lease equipment u.c.l--Cr 34497

15-4

The present value of lease is,

=125000×PVIFA10%,15×(1+0.10)

=125000×7.606×1.10

=10,45,825

Schedule of lease payments

Date Description Amount Interest Principal Lease

expense (10%) obligation
1.1.1984 Initial balance 10,45,825
1.1.1984 Payment 125000 ------ 125000 920825
31.12.84 Payment 125000 92083 32917 887908
31.12.85 Payment 125000 88791 36209 851699
31.12.86 Payment 125000 85170 39830 811869
31.12.87 Payment 125000
31.12.88 Payment 125000
31.12.89 Payment 125000
31.12.90 Payment 125000
31.12.91 Payment 125000
31.12.92 Payment 125000
31.12.93 Payment 125000
31.12.94 Payment 125000
31.12.95 Payment 125000
31.12.96 Payment 125000
31.12.97 Payment 125000

To simplify the schedule, it is assumed that the subsequent payment after the first payment is made at
the end of previous year/ lease payments after the first payment are made on December 31 of each
year.

Journal entries in the books of Beckham smelting company (Lessee)

Date Particulars DR. CR.

1.1.84 Leased equipment under capital leases----------------Dr. 1045825
Obligations under capital leases-----------------------Cr. 1045825
1.1.84 Lease expense------------------------------------------------Dr. 5000
Obligations under capital leases--------------------------Dr 125000
Cash A/c----------------------------------------------- Cr 130000
31.12.84 Amortization expense on leased equipment-----------Dr 69722
Accumulated amortization of leased equipment -Cr 69722
31.12.84 Prepaid lease expense--------------------------------------Dr. 5000
Obligations under capital leases ------------------------Dr. 32917
Interest expense ---------------------------------------------Dr. 92083
Cash A/C-------------------------------------Cr. 130000
31.12.85 Amortization expense on leased equipment-----------Dr 69722
Accumulated amortization of leased equipment -Cr 69722
31.12.85 Prepaid lease expense--------------------------------------Dr. 5000
Obligations under capital leases ------------------------Dr. 36209
Interest expense ---------------------------------------------Dr. 88791
Cash A/C-------------------------------------Cr. 130000

Ques-2

The lease started from 1984. The term of the leases were,

Rent: Tk.70000 per year for the first two years. Tk.20000 per year for the last 3 years of a 5 year term
lease. How lessee should record the rent?

Total rental payment: 70000×2+20000×3=200000

On a straight line basis, yearly rent=200000/5=40000

Date Particulars Dr. Cr

1.1.84 Prepaid rent --------------------------------Dr. 30000
Rent expense--------------------------------Dr 40000
Cash A/C--------------------------------Cr 70000
1.1.85 Prepaid rent --------------------------------Dr. 30000
Rent expense--------------------------------Dr 40000
Cash A/C--------------------------------Cr 70000
1.1.86 Rent expense-------------------------------Dr 40000
Cash A/C-------------------------------Cr 20000
Prepaid rent expense----------------Cr 20000
1.1.87 Rent expense-------------------------------Dr 40000
Cash A/C-------------------------------Cr 20000
Prepaid rent expense----------------Cr 20000
1.1.88 Rent expense-------------------------------Dr 40000
Cash A/C-------------------------------Cr 20000
Prepaid rent expense----------------Cr 20000
Page-570

The expected life of asset is 10 years. The leases started from Jan: 1, 1984. Assume that the equipment
leased for 5 years for $43,000 a year including executing cost of $3000 per year had a cost of $300000 to
the lessor. Initial direct cost $5000 were incurred in the lease. Follow the straight line method for
depreciation. How lessor should record the rent?

Journal entries in the books of lessor

Date Particular Dr. Cr.

1.1.84 Deferred initial direct costs---------------------------------Dr $5000
Cash A/C------------------------------------------------Cr $5000
1.1.84 Cash A/C--------------------------------------------------------Dr. $43000
Rent Revenue--------------------------------------- Cr $43000
31.12.84 Amortization of initial direct costs-----------------------Dr. $1000
Deferred initial direct costs----------------------------Cr. $1000
31.12.84 Depreciation expense on leased equipment-----------Dr 30000
Accumulated dep. On leased equipment-----------Cr. 30000
1.1.85 Cash A/C--------------------------------------------------------Dr. $43000
Rent Revenue--------------------------------------- Cr $43000
31.12.85 Amortization of initial direct costs-----------------------Dr. $1000
Deferred initial direct costs----------------------------Cr. $1000
31.12.85 Depreciation expense on leased equipment-----------Dr 30000
Accumulated dep. On leased equipment-----------Cr. 30000
1.1.86 Cash A/C--------------------------------------------------------Dr. $43000
Rent Revenue--------------------------------------- Cr $43000
31.12.86 Amortization of initial direct costs-----------------------Dr. $1000
Deferred initial direct costs----------------------------Cr. $1000
31.12.86 Depreciation expense on leased equipment-----------Dr 30000
Accumulated dep. On leased equipment-----------Cr. 30000
1.1.87 Cash A/C--------------------------------------------------------Dr. $43000
Rent Revenue--------------------------------------- Cr $43000
31.12.87 Amortization of initial direct costs-----------------------Dr. $1000
Deferred initial direct costs----------------------------Cr. $1000
31.12.87 Depreciation expense on leased equipment-----------Dr 30000
Accumulated dep. On leased equipment-----------Cr. 30000
1.1.88 Cash A/C--------------------------------------------------------Dr. $43000
Rent Revenue--------------------------------------- Cr $43000
31.12.88 Amortization of initial direct costs-----------------------Dr. $1000
Deferred initial direct costs----------------------------Cr. $1000
31.12.88 Depreciation expense on leased equipment-----------Dr 30000
Accumulated dep. On leased equipment-----------Cr. 30000
 1. You are given with the following information:
Cost of equipment Tk. 30,000
Lease term 3 Years (monthly in
arrear)
Implied interest rate 18.5%
You are required to calculate :( a) the monthly lease rent if it is paid at
the end of the month. (b) If it is paid at the beginning of the month. (c)
If the residual value of the machine is Tk. 2000, calculate the monthly
lease rental in arrears.

(a) Tk. 1092

(b) Tk. 1075
(c) Tk.1050
Present value of residual value: =2000

(1+.185/12)36

=2000 ×(1+0.185/12)-36

=Tk. 1153.01683

Amount to be amortized= 30000-1153.02

= Tk. 28847

PV

Monthly rental in arrear=

1– (1+r/m)-nm
Where, A=
r/m

=27.46972442

28847

Monthly rental in arrear=

27.46972442

=Tk. 1050