The Hindu Business Line : On leasing, one more

HERE is one more approach to the same leasing problem. The decision can be taken by comparing the present value of the lease option with the present value of the borrowing option. Regard must be had to the fact that this is not an investment decision. The investment decision has already been made.

The only remaining decision is whether to borrow money and buy the asset or take the asset on lease. Leasing is an alternative to borrowing. Hence the appropriate discount rate is the after-tax cost of debt.

Step 1 — PV of lease option: It is assumed that tax benefit is available in the same year. The PV of lease option is computed at after-tax cost of debt at 7.5 per cent (15 x (1-0.50). Since lease rentals are payable in equated instalments, for purposes of discounting, PVAF for 7.5 per cent for 10 years, that is, 6.865 can be used. The PV of lease rentals is Rs 51,488:

Annual lease rentals paid at the end of each year — Rs 15,000

Tax shield — 50 per cent

Outflow — Rs 7,500

Discount factor — 7.5 per cent

Present value annuity factor for ten years — 6.865

Present value of outflow under lease option — Rs 51,488

Step 2 — PV of borrowing option: Since the underlying assumption is that the discount rate is the borrowing rate, interest is ignored, because, this would involve compounding at a rate and discounting at the same rate, leading to the same value as the loan amount.

However, PV of tax saved on depreciation, and PV of net tax-adjusted terminal values are to be factored in, as shown in Working Notes 1 and 2:

WN 1: PV of tax saved on straight-line depreciation:

Annual depreciation (110,000/11) = Rs 11,000

Tax saving, 50 per cent = Rs 5,500

PV of annuity for 10 years (6.865) = Rs 37,758

WN 2: PV of net tax adjusted terminal value:

On terminal value of Rs 20,000, the tax shield is: Rs 10,000 (50 per cent)

PV of the after-tax Rs 10,000 received in year 10 = Rs 4,852 (10,000 x 0.485)

Loan amount (also PV) — (110,000)

(Less) PV of tax shield on depreciation (WN 1) — Rs 37,758

(Less) PV of tax adjusted terminal value (WN 2) — Rs 4,852

Present value of cash outflow under borrowing option — Rs 67,390