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S. D. Bala

S. D. Bala suggests answers to the November 2004 CA (Final) paper on management accounting and financial analysis

FAIR Finance, a leasing company, has been approached by a prospective customer intending to acquire a machine whose cash-down price is Rs 3 crore. The customer, in order to leverage his tax position, has requested a quote for a three-year lease with rentals payable at the end of each year, but in a diminishing manner, such that they are in the ratio of 3:2:1.

Depreciation can be assumed on a straight-line basis and Fair Finance's marginal tax rate is 35 per cent. The target rate of return for Fair Finance on the transaction is 10 per cent.

Required: Calculate the lease rentals to be quoted for the lease for three years.

Working notes: i) Assume that lease rental for Year 3 is X. Lessee demands a diminishing pattern of payment in the ratio of 3:2:1; ii) total lease pre-tax lease rentals will, therefore, be 6x; iii) Lessor expects a return of 10 per cent on the transaction; and iv) lease rentals should equal the following: a) PV of depreciation tax shield; and

b) PV of post-tax lease rentals.

Working Note 3: Computation showing PV of tax shield on depreciation is presented in Table 6.

Working note 4: An equation for PV of post-tax lease rentals is presented in Table 7.

The lease quotation for the 1st, 2nd and 3rd years respectively will be as shown in Table 8. The verification of PV is given in Table 9.

EVA

WITH the help of the following information of Hypothetical Ltd, calculate the economic value added (EVA): Financial leverage — 1.4 times; capital structure, equity capital — Rs 170 lakh; reserves and surplus — Rs 130 lakh; 10 per cent debentures — Rs 400 lakh; cost of equity — 17.5 per cent; income-tax rate — 30 per cent.

EVA is computed as the residual income.

Residual income equals: Income earned (-) less income required.

The computation of economic value added is presented in Table 1.

Forfaiting vs factoring

FORFAITING is a method of providing assistance for periods extending one year to five years to finance export receivables pertaining to capital goods exported. It can also be used as a short-term financing technique.

Factoring, in its simplest form, is an arrangement to have debts collected by a third party entity for a fee. There are also factoring arrangements under which factors undertake collection of debts and bear the default losses as well. Such an arrangement is known as factoring sans-recourse. In its broadest sense, a factoring arrangement covers debt-maintenance (administration), debt-finance, invoice discounting, debt collection or debt insurance.

The distinctions between the two are as follows:

Forfaiting: Relates to export receivables; done with an added support of a guarantee on behalf of overseas importer, and is invariably sans-recourse to the beneficiary; covers medium-term receivables; and implies transfer of major areas of currency fluctuation related risks to forfaiting agency by the exporter.

Factoring: Relates to domestic receivables; the range of factoring services are wide, and the arrangement can be either with or without recourse; and covers receivables of much shorter duration, may not always cover receivables of more than 90 days.

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