Ch 22: Lease, Hire Purchase and Project Financing

CHAPTER 22

LEASE, HIRE PURCHASE AND PROJECT FINANCING

Problem 1

Tax rate 35%

Cost of borrowing 15%
After-tax cost of borrowing 9.75%
WDV depreciation rate 25%

Rs lakh
Year 0 1 2 3 4 5 6 7 8 PV
Purchase price avoided 10.00 10.00
Lease rental -1.75 -1.75 -1.75 -1.75 -1.75 -1.75 -1.75 -1.75
After-tax lease rentals -1.14 -1.14 -1.14 -1.14 -1.14 -1.14 -1.14 -1.14 -6.12
Depreciation (Dep.) 2.50 1.88 1.41 1.05 0.79 0.59 0.44 0.33
Dep. tax-shield lost -0.88 -0.66 -0.49 -0.37 -0.28 -0.21 -0.16 -0.12 -2.40
Operating cost 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
After-tax operating cost 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
Salvage value 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
NCF 10.00 -2.01 -1.79 -1.63 -1.51 -1.41 -1.35 -1.29 -1.25
Net present value at 9.75% 1.48
IRR 5.2%

Equivalent loan
Year 0 1 2 3 4 5 6 7 8
NCF 2.01 1.79 1.63 1.51 1.41 1.35 1.29 1.25
Before-tax interest 1.28 1.10 0.94 0.79 0.64 0.49 0.33 0.17
After-tax interest 0.83 0.72 0.61 0.51 0.41 0.32 0.22 0.11
Principal repaid 1.18 1.08 1.02 1.00 1.00 1.03 1.08 1.14
Loan outstanding 8.52 7.34 6.26 5.24 4.25 3.25 2.22 1.14 0

Assumption: The equipment will have un-recovered book value of Rs1 lakh after eight years. This has been ignored in
the above calculations.

Problem 2

Equipment purchase price (lakh) 75

Tax rate 35%
WDV depreciation rate 25%
Before-tax borrowing rate 16%
After-tax borrowing rate 10.4%
Salvage value 0
Book value at the end of 5th year 17.80

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I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

Year 0 1 2 3 4 5
Purchase price avoided 75
Lease rental -20 -20 -20 -20 -20 0
After-tax lease rentals -13 -13 -13 -13 -13 0
Depreciation 18.75 14.06 10.55 7.91 5.93
Dep. tax-shield lost -6.56 -4.92 -3.69 -2.77 -6.48
Net cash flows 62 -19.56 -17.92 -16.69 -15.77 -6.48
PVF at 10.4% 1.000 0.906 0.820 0.743 0.673 0.610
PV 62.00 -17.72 -14.70 -12.40 -10.61 -3.95
Net present value at 10.4% 2.61
IRR 8.5%

Equivalent loan
Year 0 1 2 3 4 5
NCF 19.56 17.92 16.69 15.77 6.48
Before-tax interest 9.50 7.36 5.26 3.14 0.94
After-tax interest 6.18 4.78 3.42 2.04 0.61
Principal repaid 13.39 13.14 13.27 13.73 5.87
Loan outstanding 59.39 46.01 32.87 19.60 5.87 0

As per the current tax rules, a company can claim depreciation on asset (even if sold) provided the block of assets
exists with positive balance. We assume a going concern. This, therefore, implies that DTS on the asset is available for
ever. The fifth year DTS includes DTS after 5th year. This has been calculated as: book value at the end of fifth year ×
(Tax rate × Depreciation rate)/(Depreciation rate + Discount rate). The salvage value is assumed to be zero.

Problem 3

Tax rate 35%

Cost of borrowing 14%
After-tax cost of borrowing 9.10%
WDV depreciation rate 25%

Year 0 1 2 3 4 5
Purchase price avoided 30
Lease rental -8.4 -8.4 -8.4 -8.4 -8.4
After-tax lease rentals -5.46 -5.46 -5.46 -5.46 -5.46
Depreciation 7.50 5.63 4.22 3.16 4.20
Dep. Tax-shield lost -2.63 -1.97 -1.48 -1.11 -1.47
Operating cost 0 0 0 0 0
After-tax operating cost 0 0 0 0 0
Salvage value lost 0 0 0 0 -3.56
DTS on lost SV 0.91
NCF 30 -8.09 -7.43 -6.94 -6.57 -9.58
PVF at 9.1% 1.000 0.917 0.840 0.770 0.706 0.647
30.00 -7.41 -6.24 -5.34 -4.64 -6.20
Net present value 9.1% 0.18 0.18
IRR 8.9%

As per the current tax rules, a company can claim depreciation on asset (even if sold) provided the block of assets
exists with positive balance. We assume a going concern. This, therefore, implies that DTS on the asset is available for
ever. The fifth year DTS includes DTS after 5th year. This has been calculated as: book value at the end of fifth year ×
(Tax rate × Depreciation rate)/(Depreciation rate + Discount rate). The lessee also loses salvage value. Since salvage
value is deducted from gross block, DTS on salvage value will be reversed. Salvage value is riskier, and hence, it

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Ch 22: Lease, Hire Purchase and Project Financing

should be discounted at the cost of capital. In this case we do not have information about the cost of capital. Therefore,
we have used after-tax borrowing cost as the discount rate.

Problem 4

In solving this problem, the lessee’s borrowing rate is assumed to be 14%. Thus 14% is considered as the after-tax
required rate of return of the lessor.
Lessee's tax rate 0%
Lessee's cost of borrowing 14%
After-tax cost of borrowing 14%
Lessor's cost of capital 14%
Lessor's tax rate 35%
WDV depreciation rate 25%

Lessee's lease evaluation Rs lakh

Year 0 1 2 3 4 5 PV
Purchase price avoided 20.00 20.00
Lease rental -5.00 -5.00 -5.00 -5.00 -5.00
After-tax lease rentals (T=0) -5.00 -5.00 -5.00 -5.00 -5.00 -17.17
Depreciation 5.00 3.75 2.81 2.11 1.58
Dep. tax-shield lost 0.00 0.00 0.00 0.00 0.00 0.00
Operating cost 0.00 0.00 0.00 0.00 0.00
After-tax operating cost 0.00 0.00 0.00 0.00 0.00
Salvage value 0.00 0.00 0.00 0.00 0.00 0.00
NCF 20.00 -5.00 -5.00 -5.00 -5.00 -5.00
Net present value at 14% 2.83
IRR 7.93%

Break-even lease rentals of the lessee:

NPV = 20 - PV of After - tax lease rentals (ATLR) - PV of dep. tax shield = 0
NPV = 20 - 3.4331 ATLR - 0 = 0
ATLR = 20 / 3.4331 = 5.83
Since lessee’s tax rate is zero, the before- and after-tax lease rentals are same.

Lessor's lease evaluation Rs lakh

Year 0 1 2 3 4 5
Purchase price avoided -20
Lease rental 5 5 5 5 5
After-tax lease rentals (T=35%) 3.25 3.25 3.25 3.25 3.25
Depreciation 5.00 3.75 2.81 2.11 1.58
Dep. tax-shield lost 1.75 1.31 0.98 0.74 1.62
Operating cost 0 0 0 0 0
After-tax operating cost 0 0 0 0 0
Salvage value 0 0 0 0 0
NCF -20 5.00 4.56 4.23 3.99 4.87
PVF at 14% 1.000 0.877 0.769 0.675 0.592 0.519
PV -20.00 4.39 3.51 2.86 2.36 2.53
Net present value at 14% -4.36 -4.36
IRR 4.36%
Break-even lease rentals of the lessor:

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I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

NPV = 20 + PV(ATLR ) + PV(DTS) = 0

NPV = 20 + 3.433(1 − 0.35)BTLR + 4.49 = 0
BTLR = 15.51 / 2.23 = 6.95

Problem 5

Rs '000
Purchase price 150
Monthly lease rental 2.5
Tax rate 0
After-tax lease rentals 2.5
No of years 8
No of months 96
Dep rate 0
Annual Monthly
Before-tax borrowing rate 10% 0.00833
After-tax borrowing rate 10% 0.00833
PVAF (annuity due), 0.833%, 96 66.4507
PV of lease payments : [(2.5 x 66.45) 166.13
NPV of lease payments : [(2.5 x 66.45) - 150] 16.13
IRR 13.1% 1.1%
Borrowing and buying is cheaper.

Problem 6

Tax rate 35%

Cost of borrowing 14%
After-tax cost of borrowing 9.1%
Cost of capital 16%
WDV depreciation rate 25%

(a)
Year 0 1 2 3 4 5 Dis. Rate PV
Purchase price avoided 80 80.00
Lease rental -20 -20 -20 -20 -20
After-tax lease rentals (T = 35%) -13 -13 -13 -13 -13 9.1% -55.02
Depreciation 20.00 15.00 11.25 8.44 6.33
Dep. tax-shield lost -7.00 -5.25 -3.94 -2.95 -7.09 9.1% -20.53
Operating cost 0 0 0 0 0
After-tax operating cost 0 0 0 0 0 16%
Salvage value 0 0 0 0 0 16%
NCF 67 -20.00 -18.25 -16.94 -15.95 -7.09 4.45
Net present value at 9.1% 4.45
IRR 6.2%
As per the current tax rules, a company can claim depreciation on asset (even if sold) provided the block of assets
exists with positive balance. We assume a going concern. This, therefore, implies that DTS on the asset is available for
ever. The fifth year DTS includes DTS after 5th year. This has been calculated as: book value at the end of fifth year ×
(Tax rate × Depreciation rate)/(Depreciation rate + Discount rate).

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Ch 22: Lease, Hire Purchase and Project Financing

(b)
Year 0 1 2 3 4 5 Dis. Rate PV
Purchase price avoided 80 80.00
Lease rental -20 -20 -20 -20 -20
After-tax lease rentals -13 -13 -13 -13 -13 9.1% -55.02
Depreciation 20.00 15.00 11.25 8.44 6.33
Dep. tax-shield lost -7.00 -5.25 -3.94 -2.95 -7.09 9.1% -20.53
Operating cost saved 1 1 1 1 1
After-tax operating cost 0.65 0.65 0.65 0.65 0.65 16% 2.13
Salvage value 0 0 0 0 -10.00 16% -4.76
DTS lost on SV 2.57 16% 1.22
NCF 67 -19.35 -17.60 -16.29 -15.30 -6.44 3.04
Net present value 3.04
IRR 4.4%

As per the current tax rules, a company can claim depreciation on asset (even if sold) provided the block of assets
exists with positive balance. We assume a going concern. This, therefore, implies that DTS on the asset is available for
ever. The fifth year DTS includes DTS after 5th year. This has been calculated as: book value at the end of fifth year ×
(Tax rate × Depreciation rate)/(Depreciation rate + Discount rate). The lessee also loses salvage value. Since salvage
value is deducted from gross block, DTS on salvage value will be reversed. Salvage value, DTS on it and operating
costs are riskier, hence, they will be discounted at the cost of capital.

Hire purchase instalment: The above calculations reveal that after-tax lease cash flows can service net borrowing of Rs
70 lakh (67 + 3). Given the cost of borrowing of 14 per cent, we can determine the maximum up-fronted hire purchase
instalment. However, under hire purchase, the hiree will avail DTS and salvage value. Therefore, his net cash outflow
will be much less.

Amount (Rs lakh) 70

PVAF14%,5 (annuity due) 3.9137
Before-tax instalment (Rs lakh) 17.89

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I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

CASE

Case 22.1: Vishal Engineering Enterprise

This is a straight forward case requiring students to determine cash flows under a lease. The cash flows include after-
tax lease rentals, depreciation tax shield (DTS); after-tax maintenance cost and salvage value (SV). These are costs to
the lessee, but in exchange s/he avoids payment of purchase price. The instructor may like to again explain DTS, SV
and DTS on SV in the Indian context. These points would have been covered earlier in the discussion of Investment
Evaluation. In case of going concerns which have not sold their gross block and the gross block has positive balance,
DTS is available on the assets for ever. Hence, DTS for the last year (of economic life) should include DTS for the
remaining years till infinity. In case of written down depreciation, DTS will be a declining perpetuity. Hence, DTS at
the end of year n can be found as follows:
T×d 
DTSn = BVn ×   , where d = WDV depreciation rate; T = tax rate and k = discount rate
k + d
However, asset may be sold at the end of its economic life. This value, called salvage value, is a loss to the lessee
(and a gain to the lessor). Since SV has recovered the cost of the asset, DTS on this amount should be reversed. A
similar formula as discussed above can be used.
An important issue is the relevant discount rate for each cash flow under lease. In a financial lease, after-tax lease
rentals and DTS are the fixed charges that a lessee gives away (and a lessor receives). These charges cover most of the
cost of the asset. These follows are considered as equivalent to the fixed flows under a loan. Hence, they are discounted
at the after-tax cost of borrowing. The additional cash flows are operating/maintenance costs and salvage value. Both
these flows are more risky; hence, they should be discounted at the cost of capital. However, if the amount of
maintenance is fixed under a contract or known, it’s a safe cash flow and should be discounted at the after-tax cost of
borrowing. Vishal Engineering case covers all issues.
An alternative to lease is higher purchase. Unlike in the case of a lease, under hire purchase, the hiree is treated as
the owner of the asset, and he is entitled to claim tax benefit on depreciation and would receive the asset’s salvage
value when it is sold. Thus, vis-à-vis buy option, in higher purchase, the hiree avoids payment of purchase price in
exchange for after-tax hire purchase instalments. Hire purchase instalment would include both interest and repayment
of principal. Tax benefit is available only on interest. As discussed in the text of the book (chapter 22), the sum-of-the-
years-digit method could be followed to apportion interest over the hire purchase period.
Based on the discussion above the case solution is given below.

Assumptions in the case:

Investment 75 tax_rate 35%
Dep_Rate (WDV) 25% wacc 12.00%
Lease_Rental 14 HP_instalment 18.375
Maint_Cost 1.75 dts_perpetuity_disc_rate 12.00%
Salvage 6 after_tax_cost_of_debt 9.50%
r_D 9.50%

0 1 2 3 4 5 6 7 8 dis_rate NPV
Discount each cash flow at its respective rate
Investment 75.00 9.50% 75.00
DTS -6.56 -4.92 -3.69 -2.77 -2.08 -1.56 -1.17 -2.78 9.50% -19.02
After tax rental -9.10 -9.10 -9.10 -9.10 -9.10 -9.10 -9.10 -9.10 9.50% -54.14
After tax maintenance -1.14 -1.14 -1.14 -1.14 -1.14 -1.14 -1.14 -1.14 9.50% -6.18
After-tax salvage value 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 -4.48 12.00% -1.81
NPV -6.15

Analysis of Hire Purchase

Actual
Theoretical HP instalment at r_D 16.58 18.38 instalment
IRR of actual HP instalments 17.85%
Hire Purchase Cost to Vishal 15.49%

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Ch 22: Lease, Hire Purchase and Project Financing

Year 0 1 2 3 4 5 6 7 8
Principal 75.00
Instalment 18.38 18.38 18.38 18.38 18.38 18.38 18.38 18.38 0.00
56.63 -18.38 -18.38 -18.38 -18.38 -18.38 -18.38 -18.38 0.00
Interest (sum-of-year-digit) 16.00 14.00 12.00 10.00 8.00 6.00 4.00 2.00 0.00
After-tax Interest 10.40 9.10 7.80 6.50 5.20 3.90 2.60 1.30 0.00
Principal repaid 2.38 4.38 6.38 8.38 10.38 12.38 14.38 16.38 0.00
Outstanding 72.63 68.25 61.88 53.50 43.13 30.75 16.38 0.00 0.00
Implied interest rate 22.0% 20.5% 19.4% 18.7% 18.6% 19.5% 24.4%

Net Cash Flows

HP Financing 62.23 -13.48 -14.18 -14.88 -15.58 -16.28 -16.98 -17.68 0.00 15.49%
Lease Financing 65.90 -16.80 -15.16 -13.93 -13.01 -12.31 -11.79 -11.41 -8.40 12.42%