LEASE OR BUY DECISIONS

INTRODUCTION

In recent years, leasing has become a popular source

of financing in India. From the lessee's point of view,

leasing has an attraction of eliminating immediate cash

outflows, and the lease rentals can be claimed as

expenditure against the business income. On the other

hand, buying has the advantage of depreciation

allowance and interest on borrowed capital being tax

deductible. Thus, an evaluation of the two alternatives

is to be made in order to take a decision.

ILLUSTRATION

An asset costing 1,00,000 is to be acquired. There are two alternatives available to the entrepreneur. First one is Buying the asset by taking a loan of 1,00,000 repayable in five equal installments of 20,000 each along with interest @14% p.a. assuming that lease rentals, processing fees, interest as well as the principal amount are payable at the year end. The Second option is leasing the asset for which annual lease rental is 30,000 up to five years. The lessor charges 1% as processing fees in the first year. Assume the internal rate of return to be 10% and the present value factor at 10% is:

CONTD…

YEARS PV Factor

1 .909

2 .826

3 .751

4 .683

5 .621

Suggest Which alternative is better in the above case. Assume the tax rate to be 30.9 % and rate of depreciation is @15%

BUYING THE ASSET

SI NO. Particulars 1 2 3 4 5

1. Loan repayment 20,000

20,000 20,000 20,000 20,000

2. Interest @14% p.a.

14,000

11,200 8,400 5,600 2,800

3. Cash Outflow ( 1+2)

34,000

31,200 28,400 25,600 22,800

4. Depreciation@15% on WDV

15,000

12,750 10,838 9,212 7,830

5. Total of (2) and (4)

29,000

23,950 19,238 14,812 10,630

6. Tax Rate @30.9% 8,961 7,401 5,945 4,577 3,285

7. Adjusted Cash Outflow ( 3-6)

25,039

23,799 22,455 21,023 19,515

8. P.V. Factor@10% 0.909 0.826 0.751 0.683 0.621

9. Present Value of adjusted cash outflow ( 7*8)

22,760

19,658 16,684 14,359 12,119

CONTD..

Therefore, the total net present value of cash outflows is 85,760.

LEASING THE ASSET

SI NO. Particulars

1 2 3 4 5

1. Lease Rentals

30,000 30,000 30,000 30,000 30,000

2. Processing Fees

1,000 - - - -

3. Cash Outflow ( 1+2)

31,000 30,000 30,000 30,000 30,000

4. Tax Rate @30.9%

9,579 9,270 9,270 9,270 9,270

5. Adjusted Cash Outflow (3-4)

21,421 20,730 20,730 20,730 20,730

6. P.V. Factor@10%

.909 .826 .751 .683 .621

7. Present Value of adjusted Cash outflow ( 5*6)

19,472 17,123 15,568 14,159 12,873

CONTD…

• Therefore, total net present value of cash outflows = 79,195 .

• Hence in the present case, lease finance works out to be cheaper than term loan.

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