The Hindu Business Line : One question, one too many solutions

ABC Ltd is considering a proposal to acquire a machine costing Rs 1,10,000, which involves a down payment of Rs 10,000 and the balance to be payable in 10 annual equal instalments at the end of each year inclusive of interest chargeable at 15 per cent. Another option before it is to acquire the asset on a lease rental of Rs 15,000 per annum payable at the end of each year for 10 years. The following information is also available:

i) Terminal scrap value of Rs 20,000 is realisable, if the asset is purchased.

ii) The company provides 10 per cent depreciation on straight-line method on the original cost.

iii) The income-tax rate is 50 per cent.

You are required to compute and analyse the cash flows and advise as to which option is better.

This question, which appeared in the May 2005 CA (Final) Management Accounting and Financial Analysis paper, was answered in these columns (Business Line, June 20, 2005). On going through the CA study material on MAFA (pages 7.10 to 7.19), the following alternative answers are also possible.

Method II (Table 1): NPV (L) / NAL. (Refer study material, page 7.10)

Decision: Since NPV of leasing is positive buying is preferred.

Method II (Table 2): Present value analysis. (Refer study material, page 7.14)

Decision: Better to lease.

Note: On comparing the after-tax cash flows of debt versus lease it can be seen that in almost all the years (except for years 1 and 2 where the difference is not much) the after-tax cash flows of debt is greater than the after-tax cash flows of lease.

Hence it can be concluded that it is always preferable to lease. Discounting will not have any impact on this decision since any discount factor will lead to PV of lease to be less than that of PV of debt.

Method III (Table 3): Internal rate of return analysis. (Refer study material, page 7.16)

Decision: Since the cost of lease is lower than the after-tax cost of debt (7.5 per cent), leasing is preferred.

Method IV (Table 4): Bower Herringer Wiliamson method. (Refer study material, page 7.17)

Decision: Since the financial advantage exceeds the operating disadvantage in lease it is advantageous to go for leasing.

Note: For computing the advantage or (disadvantage) a cost of capital of 15 per cent is assumed.

The question is silent about the allowability of depreciation for the purposes of Income-Tax Act.

Hence a student can also assume a depreciation rate of 25 per cent as per the I-T Act. In such situation, the decision may differ.

The working table is presented in Table 5.

Instalments = 1,00,000 / 5.0188 = Rs 19,925

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