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INDEX

TOPICS PAGE NO.

1.Factoring-THEORY 3-8

2.Factoring-PRACTICAL 9-21

3.Factoring-MCQ 22-24

4.Leasing-THEORY 25-31

5.Leasing-PRACTICAL 32-61

6.Leasing-MCQ 62-64

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FACTORING-THEORY

1. INTRODUCTION TO FACTORING

This concept has not been fully developed in our count ry and most of their work is done by companies themselves.

All units’ part icularly small or medium size units have to make considerable efforts to realize the sale proceeds

without much success creat ing funct ional difficult ies for such units.

M any units under small-scale sector have become sick only because of delay/ non-realizat ion of their dues

from large units. Int roduct ion of factoring services will, therefore, prove very beneficial for such units as it w ill

free the units from hassles of collect ing receivables to enable them to concent rate on product development and

market ing.

2.DEFINITION AND M ECHANISM

2.1Definition and Concept

Basically, factoring is a kind of financial service in which a business organizat ion sells its Account Receivables

to another person, called a factor, at a discount in order to raise money. Factoring is different from bill discount ing.

In bill discount ing invoice are discounted at a certain rate to get the funds, whereas the concept of factoring is

broader. In the factoring process, the Account Receivables are sold to an outside agency.

Example - The seller sold good on credit and raised the invoice. However, the seller needs immediate money to

meet its working capital requirements i.e. meet ing day to day expenses of the business. For this purpose, he sold

the goods to an outside agency i.e. a factor. The factor pays the required amount to the seller after some deduct ing

some amount . So, the ent ire invoice amount is not paid by the factor. Rather, about 70-80% of the bill amount is

paid by the factor. The remaining amount is paid after the factor receives the ent ire bill amount from the customers

(debtors). The factor charges some commission for providing these services.

The study group appointed by the Internat ional Inst itute for the Unificat ion of Private Law (UNIDROIT), Rome,

during 1988, recommended, in general terms, the definit ion of factoring as under:

“ Factoring means an arrangement between a factor and his client which includes at least two of the following

services to be provided by the factor:

• Finance • M aintenance of debt • Collect ion of debts • Protect ion against credit risk.

However, the above definition applies only to factoring in relation to supply of goods and services:

(i)across nat ional boundaries;

(ii)to t rade or professional debtors;

(iii)when not ice of assignment has been given to the debtors. Domest ic factoring is not yet a well-defined concept

and it has been left to the discret ion of legal framework as well as t rade usage and convent ion of t he individual

count ry. In India factoring is undertaken by different bank subsidiaries like SBI Factors and Commercial Services

Ltd. Promoted by SBI and Canara Bank Factors Ltd. promoted joint ly by Canara Bank, Andhra Bank and SIDBI.

2.2M echanism of Factoring

In a factoring t ransact ion, there are three part ies - the factor, the client and the customers of the client . The

client is the person who is actually availing the factoring service. The factor providesthe factoring services and

the customers are the persons who purchases the goods and services on credit .

The mechanism of the factoring process has been depicted in the following diagram.




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The following steps are involved in the process of factoring as shown in the above diagram:

(i)Customer places an order with the client for purchase of goods and/ or services on credit .

(ii)On the basis of agreement , the client delivers the goods and sends the invoice to customers.

(iii)The client then assigns the invoice to the factor. This is generally called, “ Call sale of book debts by the client

firm to the factor.”

(iv)The factor, then, makes prepayment up to 80 per cent of the invoice value to the client .

(v)The client pays interest on advances of amount received unt il the cash is collected from customer.

(vi)The factor maintains accounts receivable of the client and sends periodical statements to the customer to

accelerate the collect ion.

(vii)On the due date, the factor collects the invoice amount from the customer.

(viii)After that , the factor releases the remaining amount to the client after adjust ing his commission/ fees.

Aforesaid steps can be explained with the help of an example:

Suppose Customer/ Client has raised an order with an invoice value of ` 500000; basis that order business

delivered the product on credit basis. After this, the business sells the invoice to factoring company to get at

least 80 per cent realized value i.e. ` 400000.

This realized value can be used for further business expansion or any product development . The business pays

an interest i.e. 5% on the advance of ̀ 400000 unt il amount realized from client . Then factoring company collects

the invoice amount from customer i.e ` 500000. After this factoring company releases the reserve amount i.e. `

1,00,000 less 5% interest charged.In this Debtor financing process, factoring charges also played a vital role for

providing the services.

The following factoring charges are levied:

• Finance charges - Computed on the prepayment outstanding in the client ’s a/ c at monthly intervals. Finance

charges are only for financing that has been availed by the client . These charges are similar to interest levied on

the cash credit facilit ies in a bank.

• Service fee - It is a nominal charge at monthly interval to cover the cost services namely - collect ion, M IS

reports, sales ledger management etc. Service fee is determined on the basis of total gross value, no. of customers,

degree of credit risk etc.

3.TYPES/ FORM S OF FACTORING

Depending upon the features built into the factoring arrangement to cater to the varying needs of t rade/

cit izens, there can be different kinds of factoring:

(i)Recourse and Non-recourse Factoring: Under a recourse factoring arrangement , the factor has recourse to




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the client (firm) if the debt purchased/ receivable factored turns out to be irrecoverable. In other words, the factor

does not assume credit risks associated with the receivables.In case of non-recourse factoring, the factor does

not have the right to recourse. The loss arising out of irrecoverable receivables is borne by t he factor, as a

compensat ion for which he charges a higher commission.

(ii)Advance and M aturity Factoring: In advance factoring, the factor paid a pre specified port ion, ranging between

three-fourths to nine tenths, of the factored receivables in advance, the balance being paid upon collect ion/ on

the guaranteed payment date. A drawing limit, as a prepayment, is made available by the factor to the client assoon as the factored debts are approved/ the invoices are accounted for. The client has to pay interest (discount )

on the advance/ repayment between the date of such payment and the date of actual collect ion from the customers/

or the guaranteed payment date, determined on the basis of the prevailing short -term rate, the financial standing

of the client and the volume of the turnover.In maturity factoring, the factoring agency does not provide any

advance to the firm. In fact , the factor makes payment to his client after collect ing the amount from the customers

at the end of the maturity period.

(iii)Full Factoring: This is the most comprehensive form of factoring combining the features of all the factoring

services specially those of non-recourse and advance factoring. It is also known as Old Line Factoring.

(iv)Disclosed and Undisclosed Factoring: In Disclosed Factoring, t he name of t he factor is disclosed in t he

invoice by the supplier-manufacturer of the goods asking the buyer to make payment to the factor.

However, in Undisclosed Factoring, the name of the factor is not disclosed in the invoice although t he factor

maintains the sales ledger of the supplier-manufacturer. The ent ire realizat ion of the business t ransact ion is

done in the name of the supplier company but all cont rol remains with the factor.

(v)Domestic and Export/ Cross Border Factoring: If t he t hree part ies involved, namely, customer (buyer),

client ,(seller-supplier) and factor (financial intermediary) are domiciled in the same count ry then it is known as

domest ic factoring. There are usually four part ies involved in a cross border factoring t ransact ion. They are:

a)Exporter (client ) b)Importer (customer) c)Export factor d)Import Factor

[It is also known as two-factor system]

4.FUNCTIONS OF A FACTOR

The main functions of a factor could be classified into five categories:

• M aintenance/ administration of sales ledger: The factor maintains the clients’ sales ledgers. On t ransact ing a

sales deal, an invoice is sent to the customer and a copy of the same is sent to the factor. The factor also gives

periodic reports to the client .

• Collection facility: The factor undertakes to collect the receivables on behalf of the client relieving him of the

problems involved in collect ion, and enables him to concent rate on other important funct ional areas of the

business. It also enables the client to reduce the cost of collect ion by way of savings in manpower, t ime and

efforts.

• Financing Trade Debts: The unique feature of factoring is that a factor purchases the book debts of its clients

at a price and the debts are assigned in favour of factor who is usually willing to grant advances to the extent of

80% of the assigned debts.

• Credit Control and Credit Protection: Assumpt ions of credit risk is one of the most important funct ions of the




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factor. This service is provided where debts are factored without recourse. The factor in consultat ion with the

client fixes credit limits for approved customers.

• Advisory Services: By virtue of their specialized knowledge and experience in finance and credit dealings and

access to extensive credit informat ion; factors can provide the following

informat ion services to the clients:

(i)Customer ’s percept ion of the client ’s products, changing in market ing st rategies, emerging t rends etc.

(ii)Audit of the procedures followed for invoicing, delivery and dealing with sales returns.

(iii)Int roduct ion to the credit department of bank/ subsidiaries of banks engaged in leasing, hire-purchase, merchant

banking.

5.BENEFITS OF FACTORING

The benefits of factoring have been discussed as follows:

• Factoring provides immediate cash flow in the form of 80% of the invoice value which helps in building the

liquidity posit ion of the client . Also, this proport ion of finance is higher than bank finance against credit sales.

• It also plays an important role in client ’s working capital finance.

• The cash realized by receiving advance amount from the factor can be usedto accelerate the product ion cycle.

• The client need not have to spend t ime on sales ledger maintenance, follow up and collect ion of receivables as

this can be done by factoring company who buys such receivables. This helps in saving the precious t ime of the

client as it can concent rate on its core act ivit ies such as product ion, market ing etc.

• This provides comprehensive credit cont rol system which helps in assessing t he qual i t y o f debt ors and

monitoring their financial health.

The factoring process helps in reducing the average receivables collect ion period. As a result , the total operat ing

cycle t ime of the client is also reduced. This will ult imately leads to efficient working capital management .

6. FACTORS INHIBITING THE GROWTH OF FACTORING IN INDIA

The factoring indust ry has grown up rapidly around the world. M ore than one lakh businesses are current ly

using factoring to sett le their t rade t ransact ion. However, the factoring market in India is minuscule.

There are various factors which inhibits the overall growth of factoring markets in India which are described

as below:

(i)Lack of credit appraisal system and authent ic client data base have rest ricted the growth model of factoring

and its arrangements.

(ii)Higher stamp duty while assigning the invoice to the factor will increase the cost of the client which leads to

reduct ion in factoring arrangements.

To remove the above limitations and expand the factoring market in India, the following can be suggested:

(i)Do away with stamp duty or at least reduce it .

(ii)Incorporate a separate company which will give a t rue and fair credit appraisal report and which will cover all

aspect of client ’s informat ion and their accounts.

(iii)Factoring companies should expand their network and branches especially to those localit ies where small

scale units are located.

(iv)Work shop and seminars should be organized by factoring companies to enhance awareness and usefulness

of the factoring process.




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7. FORFAITING

Forfait ing is a form of financing of receivables pertaining to internat ional t rade. It denotes the purchase of

t rade bills/ promissory notes by a bank/ financial inst itut ion without recourse to the seller. The purchase is in the

form of discounting the documents covering the entire risk of nonpayment in collection. All risk and collectionproblems are fully the responsibilit y of the purchaser (forfaiter) who pays cash to the seller after discount ing the

bills/ notes.

Difference between Forfaiting vs Export Factoring

(a)A forfaiter discounts the ent ire value of the note/ bill. In a factoring arrangement the extent of financing

available is 75-80%.

(b) The forfaiter ’s decision to provide financing depends upon the financing standing of the availing bank. On the

other hand in a factoring deal the export factor bases his credit decision on the credit standards of the exporter.

(c) Forfait ing is a pure financial agreement while factoring includes ledger administ rat ion as well as collect ion.

(d) Factoring is a short -term financial deal. Forfait ing spreads over 3-5 years.

8. PRACTICAL EXAM PLES -COVERED LATER ON IN PTACTICAL PART

9. REGULATORY ASPECTS OF FACTORING

In India, Regulatory Aspects of Factoring can be referred from Factoring Regulat ion Act , 2011 and Non-Banking

Financial Company - Factors (Reserve Bank) Direct ions, 2012.

9.1Provisions in brief from the Factoring Regulation Act, 2011

(i)No factor shall commence or carry on the factoring business unless it obtains a cert ificate of regist rat ion from

the Reserve Bank to commence or carry on the factoring business under this Act .

For the removal of doubts it is hereby clarified that a non-banking financial company engaged in factoring business

shall be t reated as engaged in factoring business as its “ principal business” if it fulfils the following conditions,

namely:—

(a) If it s financial assets in the factoring business are more than fifty per cent . of its total assets or such per cent .

as may be st ipulated by the Reserve Bank; and

(b)If it s income from factoring business is more than fifty per cent . of the gross income or such per cent . as may

be st ipulated by the Reserve Bank.

(ii)The Reserve Bank may, if it considers necessary in t he interest of business enterprises availing factoring

services or in the interest of factors or interest of other stake holders give direct ions to the factors either generally

or to any factor in part icular or group of factors in respect of any mat ters relat ing to or connected with the

factoring business undertaken by such factors. If any factor fails to comply with any direct ion given by the Reserve

Bank, the Reserve Bank may prohibit such factor from undertaking the factoring business.

The person who has to receive any amount from the debtors or who is owner of any receivable shall, at the t ime

of entering an agreement with the factor disclose to the factor any defences and right of set off that may be

available to the debtor. Upon entering the agreement , any security created to secure the payment of receivable

shall vest in the factor and he is eligible to exercise all the rights and remedies whether by way of damages or

otherwise which would otherwise available to the owner of receivable.

Before demanding any payment from the debtors, the factor shall give a proper not ice to him. After receiving

the not ice, the debtors shall make the required payment to the factor and this will fully discharge the liabilit y of

the debtor.




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In case, no not ice for payment is received by the debtor, and he makes the required payment to the owner of

receivable, such amount shall be paid forthwith by him to the factor. So, the owner of the receivable acts as a

t rustee in this situat ion and he holds the amount received from the debtor in t rust for the factor.

If any modificat ion in the original cont ract takes place between the owner of receivable and the factor, w ill not

be binding against the factor unless he consents to it . If the owner of receivable commits any breach of original

cont ract with debtor, the debtor can claim any loss or damage caused to him in consequence of that .

Every factor shall for the purpose of regist rat ion,file the part iculars of every t ransact ion of assignment of

receivables to the Cent ral Regist ry to be set up under Securit isat ion and Reconst ruct ion of Financial Assets and

Enforcement of Security Interest (SARFAESI) Act , 2002 within 30 days from the date of such assignment or from

the date of establishment of such regist ry.

9.2.As per the Non-Banking Financial Company - Factors (Reserve Bank) Directions, 2012

Following addit ional points may be noted with relat ion to factoring in this regard:

(i) An ent ity not registered with the Reserve Bank of India (RBI) may conduct the business of factoring if it is an

ent ity ment ioned in Sect ion 5 of the Act i.e. a bank or any corporat ion established under an Act of Parliament or

State Legislature, or a Government Company as defined under sect ion 617 of the Companies Act , 1956.

(ii) Every company seeking regist rat ion as NBFC-Factor shall have a minimum Net Owned Fund (NOF) of ̀ 5 crore.

Exist ing companies seeking regist rat ion as NBFC-Factor but do not fulfil the NOF criterion of ‘ 5 crore may approach

the Bank for t ime to comply with the requirement .

(iii)A new company that is granted Cert ificate of Regist rat ion (CoR) by the RBI as NBFC-Factor shall commence

business within six months from the date of grant of CoR by the RBI.

(iv) An NBFC-Factor shall ensure that its financial assets in the factoring business const itute at least 50 per cent

of its total assets and the income derived from factoring business is not less than 50 per cent of its gross income.




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NET BENEFIT OF FACTORING

QUESTION NO.1A company is considering to engage a factor, the following informat ion is available

(i)The current average collect ion period for the Company's debtors is 80 days and ½% of debtors default . The

factor has agreed to pay money due after 60 days and will take the responsibilit y of any loss on account of bad

debts.

(ii)The annual charge for the factoring is 2% of turnover payable annually. Administ rat ion cost saving is likely to

be ` 1,00,000 per annum.

(iii)Annual sales, all on credit , are ` 1,00,00,000. Variable Cost is 80% of sales price. The Company's cost of

borrowing is 15% per annum. Assume the year is consist ing of 365 days.Should the Company enter into a factor-

ing agreement?

EFFECTIVE COST OF INTEREST UNDER FACTORING

QUESTION NO. 2AX Ltd. has a total sales of ` 4 crores and its average collect ion period is 90 days. The past

experience indicates that bad-debt losses are 1.5% on Sales. The expenditure incurred by the firm in administering

its receivable collect ion efforts are ` 6,00,000. A factor is prepared to buy the firm’s receivables by charging 2%

Commission. The factor will pay advance on receivables to the firm at an interest rate of 18% p.a. after withholding

10% as reserve ,other required commission & interest .Calculate the effect ive cost of factoring to the Firm.(Assume

= 360 days)

QUESTION NO.2BM / s At lant ic Company Limited with a turnover of ` 4.80 crores is expect ing growth of 25% for

forthcoming year. Average credit period is 90 days. The past experience shows that bad debt losses are 1.75% on

sales. The Company’s administering cost for collect ing receivables is ` 6,00,000/ -.It has decided to take factoring

service of Pacific Factors on terms that factor will buy receivables by charging 2% commission and 20% risk with

recourse. The factor will pay advance on receivables to the firm at 16% interest rate per annum after withholding

10% as reserve,other required commission & interest .Calculate the effect ive cost of factoring to the firm. (Assume

360 days in a year)

Solution:

Effect ive Cost of Factoring : 100×Lakhs 126.72

Lakhs 18.72= ` 14.77%

Working Note:

Expected Turnover = ` 4.80 crore + 25% i.e. ` 1.20 crore = ` 6.00 crore

Working Note ` in Lacs

Calculation Of Net Advance to be Received:

Debtors ` 6.00 crore x 90/360 150.00

Less: 10% withholding (15.00)

Less: Commission 2% (3.00)

Amount Of Advance 132.00

Less: Interest @16% for 90 days on ` 132 lacs 5.28__

Net Advance Amount Received 126.72

Working Note

FACTORING-PRACTICAL




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Calculation of Net Cost Paid:

Cost(A)

Total Commission ` 6.00 crore x 2% 12.00

Total Interest ` 5.28 lacs x 360/90 21.12

Cost 33.12

Benefit(B)

Adminst rat ion Cost Saved 6.00

Saving in Bad Debts (` 600 lacs x 1.75% x 80%) 8.40

Benefit 14.40

Net Cost Paid (A-B) 18.72

QUESTION NO.2CPQR Ltd. has credit sales of ` 165 crores during the financial year 2014-15 and its average

collect ion period is 65 days. The past experience suggests that bad debt losses are 4.28% of credit sales.

Administ rat ion cost incurred in collect ion of its receivables is ` 12,35,000 p. a. A factor is prepared to buy the

company’s receivables by charging 1.95% commission. The factor will pay advance on receivables to the company

at an interest rate of 16% p.a. after withholding 15% as reserve,commission & interest .

Estimate the effect ive cost of factoring to the company assuming 360 days in a year.

Solution:

Effect ive Cost of Factoring : 100×24.0272

.0095-= -0.0395%

Note:Negat ive sign indicates benefit due to factoring.

Working Note:

Calculation Of Net Amount Of Advance Received :

Particulars ` crore

Debtors = ` 165 crore x 65 / 360 29.7916

Factoring commission = ` 29.7916crore x 1.95/100 0.5809

Factoring reserve = ` 29.7916 crore x 15/100 4.4687

Amount Of Advance 24.742

Factor will deduct his interest @ 16%:-24.742x16/100 x 65/360 .7148

Net Amount Of Advance Received 24.0272

Working Note:


Cost:

Factoring commission (` 0.5809 crorex 360/ 65) 3.2173

Interest charges (` 0.7148 crorex 360 / 65) 3.9589

Total 7.1760

Benefit:

Cost of credit administ rat ion saved 0.1235

Cost of Bad Debts (` 165 crorex 4.28 / 100) avoided 7.0620

Total 7.1855

Net cost to the Firm (` 7.1760 - ` 7.1855) -0.0095

QUESTION NO.2DA Ltd. Has annual credit sales of ` 219 lakh and its average collect ion period is 50 days. The

past experience indicates that bad debt losses are around 2% of credit sales. The factoring is expected to save `

2 lakh in administ rat ion costs and also to eliminate all bad debt losses. The factor has agreed to advance 80% of

the receivables at 15% p.a. deduct ing its factoring commission and interest .Compute the net factoring cost if




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factoring commission is 2%.

Solution:

Effect ive Cost of Factoring : 100×22.92

1.504= 6.56%

Working Note:


Debtors = (` 219lakh / 365) X 50 = ` 30 lakh

Amount Of Advance = 80% of ` 30 lakh = ` 24 lakh

Factoring Commission = 2% on ` 30 lakh = ` 0.6 lakh

= ` 23.4 lakh

Interest for 50 days on ` 23.4 lakh

= ` 23.4 lakh x 15/100 x 50/365 = ` 0.48 lakh

Net Amount Of Advance Received = ` 22.92 lakh

Working Note:


Cost:

Factoring commission 2% on ` 219 ` 4.38 lakh

Interest Paid On Advance 0.48 x 365/50 ` 3.504 lakh

Cost ` 7.884 lakh

Benefit:

Bad Debt = 2% on ` 219 lakh ` 4.38 lakh

Administ rat ion cost saved ` 2.00 lakh

Benefit ` 6.380 lakh

Net Cost ` 1.504 lakh

SPECIAL CASE UNDER FACTORING WHEN COM PANY IS DEPENDENT ON OVERDRAFT FACILITY

QUESTION NO.3AThe following financial informat ion related to N Ltd.:

Sales (all on credit ) ` 37400000

Trade receivables ` 4600000

The average variable overdraft interest rate in each year was 5%. A factor has offered to take over the administ rat ion

of t rade receivables on a nonrecourse basis for an annual fee of 3% of credit sales. The factor will maintain a

t rade receivables collect ion period of 30 days and N Ltd will save ` 1,00,000 per year in administ rat ion costs and

` 3,50,000 per year in bad debts. A condit ion of the factoring agreement is that the factor would advance 80% of

the face value of receivables at an annual interest rate of 7%. Evaluate whether the proposal to factor t rade

receivables is financially acceptable.(For calculat ion, assume one year = 365 days)

QUESTION NO.3BThe credit sales and receivables of DEF Ltd. at the end of year are est imated at ` 561 lakhs and

` 69 lakhs respect ively.

The average variable overdraft interest rate is 5% p.a.

DEF Ltd. is considering a factoring proposal for its receivables on a non-recourse basis at an annual fee of 1.25%

of credit sales.

As a result , DEF Ltd. will save ` 1.5 lakhs p.a. in administ rat ive cost and ` 5.25 lakhs p.a. as bad debts.

The factor will maintain a receivables collect ion period of 30 days and will provide 80% of face value of receivables

as advance at an interest rate of 7% p.a. You may take 365 days in a year for t he purpose of calculat ion of

receivables.Required:Evaluate the viability of factoring proposal.




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Solution:

Calculation Of Net Benefit Due To Factoring

Total Savings (A)

Interest Earned Due Reduct ion In Debtors ` 22,89,041 @ 5% 1,14,452

Saving of Administ rat ion costs 1,50,000

Saving of Bad debts 5,25,000

Overdraft Interest Saved Due To Advance Received ` 36,88,767@ 5% 1,84,438

Total Benefit 9,73,890

Total Cost of Factoring (B)

Interest Paid ` 36,88,767 @ 7% 2,58,214

Commission Charges (` 5,61,00,000 @ 1.25%) 7,01,250

Total 9,59,464

Net Saving (A) - (B) 14,426

Decision: Since Net Saving is posit ive the proposal is viable and can be accepted.

Working Note:Reduct ion In Debtors

Exist ing Debtors 69,00,000

New Debtors 365

30×000,00,561 46,10,959

Reduct ion in Debtors(` 69,00,000 - ` 46,10,959) 22,89,041

Working Note: Calculat ion Of Advance Amount

Advances ` 46,10,959 @ 80% ` 36,88,767

EFFECTIVE ANNUALIZED COST UNDER DISCOUNT OPTION

QUESTION NO.4Champak Limit ed is a small manufacturing company of small t eddy bears for babies and is

suffering cash flow crunch. The company had already ut ilized its maximum overdraft facilit y. The average sale (at

invoice value) of Champak Limited is ` 40,00,000 per month, and customers are allowed to pay in 45 days from

the date of invoice. The past experience indicates that bad-debt losses are 1.5% on sales. To meet t he cash

crunch situat ion CFO of the company has suggested following two opt ions:

Option 1 (Factoring): Bank X (a factoring firm) is ready to provide factoring services and would advance 75% of

the value of the invoices, deduct ing commission & interest @ 10 percent per annum. For these factoring services

Bank X, would charge a service fee of 2% of the total invoice value. It is est imated that by using t he factoring

services, Champak Limited would able to save administ rat ion costs of ` 50,000 per month.

Option 2 (Offering Discount): Champak Limited could also offer a cash discount of 2% discount for payments

made within 10 days of invoicing.

(i)Calculate effect ive annualized net cost / cost under these two opt ions assuming factoring agreement is on

recourse basis.

(ii)Calculate effect ive annualized net cost / cost under these two opt ions assuming factoring agreement is on non-

recourse basis and X Bank would charge services charges @3% instead of 2%.

Note: Assume 360 days in a year.

Solution:

(i)(a)EffectiveAnnualized Net Cost under Factoring option (With Recourse)

Effect ive Cost of Factoring : 100×43,25,250

7,98,000= 18.45%

Working Note:




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Cost:

Factoring commission (` 1,20,000 x 360/45) 9,60,000

Interest charges (` 54,750 x 360/45) 4,38,000_

Cost 13,98,000

Benefit:

Cost of credit administ rat ion saved (` 50,000 x 12) 6,00,000

Benefit 6,00,000

Net Cost 7,98,000

Working Note:


Particulars `Average level of Receivables = ` 40,00,000 x 12 x 45/360 60,00,000

Amount available for advance = 75% of ` 60,00,000 45,00,000

Factoring commission = ` 60,00,000 x 2/100 1,20,000

43,80,000

Factor will deduct his interest @ 10% :

` 43,80,000x10x45/100x360 ` 54,750

Net Amount Of Advance Received 43,25,250

(b)Effective Annualized Cost under Discount option

Since Champak Ltd. is offering a discount of 2% for payment in 10 days the customer who opts for this opt ion

instead of 45 days are paying 35 days earlier. Accordingly,

98(1 + d) = 100 i.e.d = 2.04 %

By using following formula of simple interest the effect ive annual cost of discount opt ion can be found as follows:

2.04% x 360/35 = 20.98%

(ii)(a)Effective Annualized Net Cost under Factoring option (Without Recourse)

Effect ive Cost of Factoring : 100×42,66,000

5,52,000= 12.94%

Working Note:


Cost:


Interest charges (` 54,000 x 360/45) 4,32,000_

Cost 18,72,000

Benefit:

Cost of credit administ rat ion saved (` 50,000 x 12) 6,00,000

Cost of Bad Debts (` 4,80,00,000 x 1.5/100) avoided 7,20,000_

Benefit 13,20,000

Net Cost 5,52,000

Working Note:


Particulars `Average level of Receivables = 40,00,000 x 12 x 45/360 60,00,000

Amount available for advance = 75% of Rs.60,00,000 45,00,000

Factoring commission = 60,00,000 x 3/100 1,80,000

43,20,000

Factor will deduct his interest @ 10% :




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43,20,000x10x45/100x360 ` 54,000_

Net Amount Of Advance Received ` 42,66,000

Effective Annualized Cost under Discount option

The effect ive annual cost of discount opt ion is 20.98% (as computed above)

EPQ(EXTRA PRATICAL QUESTIONS)

QUESTION NO. 1The credit sales and receivables of M / s M Ltd. at the end of the year are est imated at ̀ 3,74,00,000

and ` 46,00,000 respect ively.The average variable overdraft interest rate is 5%. M Ltd. is considering a proposal

for factoring its debts on a non-recourse basis at an annual fee of 3% on credit sales. As a result , M Ltd. will save

` 1,00,000 per year in administ rat ive cost and ` 3,50,000 as bad debts. The factor will maintain a receivables

collect ion period of 30 days and advance 80% of the face value thereof at an annual interest rate of 7%. Evaluate

the viability of the proposal.

Solution:

Est imated Receivables 46,00,000

Est imated Receivables under Factor (` 3,74,00,000 x 30/365) 30,73,973

Reduct ion in Receivables (` 46,00,000 - ` 30,73,973) 15,26,027

Total Savings (A)

Reduct ion in finance costs ` 15,26,027 @ 5% 76,301

Saving of Administ rat ion costs 1,00,000

Saving of Bad debts Total 3,50,000

5,26,301

Total Cost of Factoring (B)

Interest on advances by Factor

Advances ` 30,73,973 @ 80% 24,59,178

Interest on ` 24,59,178 @ 7% 1,72,142

Overdraft Interest Saved on ` 24,59,178 @ 5% (` 1,22,959) 49,183

Chages payable to Factor (` 3,74,00,000 @ 3%) 11,22,000

11,71,183

Net Saving (A) - (B) (6,44,882)

Since Net Saving is negat ive the proposal is not viable and hence should not be accepted.

QUESTION NO. 2Ext racts from the recent financial statements of ABC Ltd. are given below.

` ‘000

Turnover 21,300

Cost of sales 16,400

Gross Profit 4,900

Non-current assets 3,000

Current assets

Inventory 4,500

Trade receivables 3,500 8,000

Total Assets 11,000

Trade payables 3,000

Overdraft 3,000 6,000

Equity Shares 1,000

Reserves 1,000 2,000

Debentures 3,000

Total Liabilit ies 11,000




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XYZ Fincorp, a factor has offered to manage the t rade receivables of ABC Ltd. under a servicing and factor-

financing agreement . XYZ expects to reduce the average t rade receivables period of ABC from its current level to

35 days; to reduce bad debts from 0.9% of turnover to 0.6% of turnover; and to save ABC ` 40,000 per year in

administ rat ion costs.

The XYZ would also make an advance to ABC of 80% of the revised book value of t rade receivables. The interest

rate on the advance would be 2% higher than the 7% that ABC current ly pays on its overdraft . The XYZ would

charge a fee of 0.75% of turnover on a with-recourse basis. or a fee of 1.25% of turnover on a non-recourse basis.

Assuming 365 days in a year and all sales and purchases are on credit you are required to evaluate the proposal

of XYZ Fincorp.

Working Notes:

(i)Present Trade receivables period = 365 x 3,500/21,300 = 60 days

(ii)Reduct ion in t rade receivables under factoring arrangement `

Current t rade receivables 3,500,000

Revised t rade receivables (` 21,300,000 x 35 / 365) 2,042,466

Reduct ion in t rade receivables 1,457,534

Calculation of benefit of with-recourse offer

As the XYZ’s offer is with recourse, ABC will gain the benefit of bad debts reducing from 0.9% of turnover to 0.6%

of turnover.

Finance cost saving = ` 1,457,534 x 0.07 = 102027

Administ rat ion cost saving 40000

Bad debt saving = ` 21,300,000 x (0009 — 0.006) 63900

Total saving 205927

Addit ional interest on advance(` 2,042.466 x 0.8 x 0.02) 32680

Net benefit before factor fee (A) 173247

With-recourse factor fee = ` 21,300,000 x 00075 (B) 159750

Net benefit of w ith-recourse ofer (A) — (B) 13497

Calculation of benefit of non-recourse offer

As the offer is without recourse, the bad debts of ABC will reduce to zero, as these will be carried by the XYZ, and

so the company will gain a further benefit of 0.6% of turnover.

Net benefit before with-recourse factor fee (A) as above 173,247

Non-recourse factor fee ` 21,300,000 x 0.0125 (D) 266,250

Net cost before adjust ing for bad debts (E) = (D) — (A) 93,003

Remaining bad debts eliminated = ` 21,300,000 x 0.006 (F) 127,800

Net benefit of non-recourse ofer (F) — (E) 34,797

Decision : The non-recourse offer from the factor is financially more att ract ive than the with-recourse ofer.

QUESTION NO. 3M / s At lant ic Company Limited with a turnover of ` 4.80 crores is expect ing growth of 25% for

forthcoming year. Average credit period is 90 days. The past experience shows that bad debt losses are 1.75% on

sales. The Company’s administering cost for collect ing receivables is ` 6,00,000/ -.It has decided to take factoring

service of Pacific Factors on terms that factor will buy receivables by charging 2% commission and 20% risk with

recourse. The factor will pay advance on receivables to the firm at 16% interest rate per annum after withholding

10% as reserve.Calculate the effect ive cost of factoring to the firm. (Assume 360 days in a year)

Solution:

Expected Turnover = ` 4.80 crore + 25% i.e. ` 1.20 crore = ` 6.00 crore

` in Lacs ` in Lacs

Advance to be given:




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Debtors ` 6.00 crore x 90 / 360 150.00

Less: 10% withholding 15.00 135.00

Less: Commission 2% 3.00

Net payment 132.00

Less: Interest @16% for 90 days on ` 132 lacs 5.28

Net Advance Given 126.72

Calculation of Average Cost:

Total Commission ` 6.00 crore x 2% 12.00

Total Interest ` 5.28 lacs x 360/90 21.12 33.12

Less: Admin. Cost 6.00

Saving in Bad Debts (` 600 lacs x 1.75% x 80%) 8.40 14.40

18.72

Effect ive Cost of Factoring : ` 18.72 lacs/ ` 126.72 lacs ×100 = ` 14.77%

QUESTION NO.4PQR Ltd. has credit sales of ` 165 crores during t he financial year 2014-15 and its average

collect ion period is 65 days. The past experience suggests that bad debt losses are 4.28% of credit sales.

Administ rat ion cost incurred in collect ion of its receivables is ` 12,35,000 p. a. A factor is prepared to buy the

company’s receivables by charging 1.95% commission. The factor will pay advance on receivables to the company

at an interest rate of 16% p.a. after withholding 15% as reserve,commission & interest .

Est imate the effect ive cost of factoring to the company assuming 360 days in a year.

Solution:

Particulars ` crore

Average level of Receivables = ` 165 crore x 65/360 29.7916

Factoring commission = ` 29.7916crore x 1.95/100 0.5809

Factoring reserve = ` 29.7916crore x 15/100 4.4687

Amount available for advance = ` 29.7916 — (0.5809 + 4.4687) 24.742

Factor will deduct his interest @ 16%:-

` 24.742x16/100 x 65/360 0.7148

Advance to be paid = (` 24.742—` 0.7148) 24.0272

Annual Cost of Factoring to the Firm p.a:

Factoring commission (` 0.5809 crore x 360/65) 3.2173

Interest charges (` 0.7148 crore x 360/65) 3.9589

Total 7.1760

Firm’s Savings on taking Factoring Service p.a:

Cost of credit administ rat ion saved 0.1235

Cost of Bad Debts (` 165 crore x 4.28/100) avoided 7.0620

Total 7.1855

Net cost to the Firm (` 7.1760 - ` 7.1855) -0.0095

Effect ive cost of factoring to the firm - -0.0395%

-0.0095/24.0272 x 100

Note:Negat ive sign indicates benefit due to factoring.

QUESTION NO.5A Ltd. Has annual credit sales of ̀ 219 lakh and its average collect ion period is 50 days. The past

experience indicates that bad debt losses are around 2% of credit sales. The factoring is expected t o save ` 2

lakh in administ rat ion costs and also to eliminate all bad debt losses. The factor has agreed to advance 80% of

the receivables at 15% p.a. after deduct ing its factoring commission and interest .Compute the net factoring cost

if factoring commission is 2%.




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Solution:

Average receivable = (` 219lakh/365) X 50 = ` 30 lakh

Factoring Commission = 2% on ` 30 lakh = ` 0.6 lakh

Amount available for advance = 80% of ` 30 lakh – Factoring commission (` 0.6 lakh) = ` 23.4 lakh.

Interest for 50 days on ` 23.4 lakh = ` 23.4 lakh x 15/100 x 50/365= ` 0.48 lakh

The advance remit ted to client = ` 23.4 lakh – ` 0.48 lakh= ` 22.92 lakh

Factoring cost for 50 days = Factoring commission + Interest

= ` 0.6 lakh + ` 0.48 lakh = ` 1.08 lakh

Factoring cost for year = (` 1.08 lakh) x (365/50) = ` 7.884 lakh

Net Factoring Cost

Particulars ` lakh

Factoring cost per year 7.884

Less: Costs saved per year

Bad Debt = 2% on ` 219 lakh 4.38

Administ rat ion cost saved 2.00 6.380

Net Factoring cost per year 1.504

Advance 22.920

Net Factoring cost per year (in %) = (1.504/22.92) X 100 6.56%

QUESTION NO.6Beanstalk Ltd. manages its accounts receivable internally by its sales and credit department .

The cost of sales ledger administ rat ion stands at ` 10 crores annually. The company has a credit policy of 2/10,

net 30. Past experience of the company has been that on an average 40 percent of the customers avail of the

discount by paying within 10 days while the balance of the receivables are collected on average 90 days after the

invoice date. Bad debts of the company are current ly 1.5 percent of total sales. The projected sales for the next

year are ` 1,000 crores.

Beanstalk Ltd. finances its investment in debtors through a mix of bank credit and own long term funds in the

rat io of 70:30. The current cost of bank credit and long term funds are 13 percent and 15 percent respect ively.

With escalat ing cost associated with the in house management of debtors coupled with the need to unburden the

management with the task so as to focus on sales promot ion, the Company is examining the possibilit y of

outsourcing its factoring service for managing its receivable and has two proposals on hand with a guaranteed

payment within 30 days.

The main elements of the Proposal I from Finebank Factors Ltd. are:

• Advance, 88 percent and 84 percent for the recourse and non recourse arrangements.

• Discount (Interest ) charge in advance, 21 percent for with recourse and 22 percent without recourse.

• Commission, 4.5 percent without recourse and 2.5 percent with recourse.

The main elements of the Proposal II from Roughbank Factors Ltd. are:

• Advance, 84 percent with recourse and 80 percent without recourse respect ively.

• Discount (Interest )charge upfront without recourse 21 percent and with recourse 20 percent .

• Commission upfront , w ithout recourse 3.6 percent and with recourse 1.8 percent .

The opinion of the Chief M arket ing M anager is that in the context of the factoring arrangement , his staff would

be able exclusively focus on sales promot ion which would result in addit ional sales of 10% of projected sales.

Kindly advice as a financial consultant on the alternat ive proposals. What advice would you give? Why?

Solution:

(a)Financial Analysis of Receivable M anagement Alternatives

(A) In-House M anagement (` Crores)

Cash Discount (` 1000 crore x 40% x 2%) 8.00

Bad Debt (` 1000 crore x 1.50%) 15.00

Avoidable Administ rat ive and Selling Cost 10.00




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Cost of Investment in Receivable* 21.61

54.61

* Cost of Investment in Receivable

Average Collect ion Period (0.40 x 10 days + 0.60 x 90 days) 58 days

Investment in Debtors (` 1000 crores x 58/365) ` 158.90 crores

Cost of Investment (0.70 x 13 + 0.30 x 15) 13.60%

Cost of Investment in Receivable (` 158.90 crores x 13.60%) ` 21.61 crores

(B) Finebank Proposal With Recourse Without Recourse

Factoring Commission

(` 1100 crores x 2.5%) and 27.50

(` 1100 crores x 4.5%) 49.50

Discount(Interest) Charges On Advance

1st Presentation:

(` 1100 crores – ` 27.50 crores) 0.88 x 21% x 30/365 16.29 -

(` 1100 crores – ` 49.50 crores) 0.84 x 22% x 30/365 - 15.96

or

2nd Presentation:

(` 1100crores x 30/365 – ` 27.50crores x 30/365) 0.88 x 21% 16.29 -

(` 1100crores x 30/365 – ` 49.50crores x 30/365) 0.84 x 22% x 30/365 - 15.96

Cost of Long Term Funds Invested in Debtors [Tutorial Note 1]

(Rs.1100 crores – Rs.943.80 crores) 0.15 x 30/365 1.93 -

(Rs.1100 crores – Rs.882.42 crores) 0.15 x 30/365 -___ 2.68_

45.72 68.14

Tutorial Note : ` 1100 crore is credit sale, hence fund blocked in Debtor is ` 1100 crore.This fund blockage is

reduced by advance given by factor which is ` 943.80 crore (` 1100 crores – ` 27.50 crores) in first case.However

amount of fund st ill blocked in debtor is ` 156.2 crore(` 1100 crores – ` 943.80 crores) for which company will

have to bear cost at the rate of 15% assuming it to funded from own long term funds.

(C) Roughbank Proposal With Recourse Without Recourse


(` 1100 crores x 1.8%) and 19.80

(` 1100 crores x 3.6%) 39.60

Discount (Interest) Charges

(` 1100 crores – ` 19.80 crores) 0.84 x 20% x 30/365 14.92 -

(` 1100 crores – ` 39.60 crores) 0.80 x 21% x 30/365 - 14.64

Alternat ive Presentat ion as above may also be taken

Cost of Long Term Funds Invested in Debtors

(` 1100 crores – ` 907.37 crores) 0.15 x 30/365 2.37 -

(` 1100 crores – ` 848.32 crores) 0.15 x 30/365 -___ 3.10

37.09 57.34

Decision Analysis: With Recourse

Fine bank Rough bank

Benefits (` 54.61 crore – ` 15 crore) 39.61 39.61

Cost s 45.72 37.09

Bad Debts (6.11) 2.52

Decision Analysis: Without Recourse

Fine bank Rough bank

Benefits 54.61 54.61

Cost s 68.14 57.34




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(13.53) (2.73)

Advice: The proposal of Roughbank with recourse should be accepted.

QUESTION NO.7A Ltd. has an export sale of ` 50 crore of which 20% is paid by importers in advance of dispatch

and for balance the average collect ion period is 60 days. However, it has been observed that these payments

have been running late by 18 days. The past experience indicates that bad debt losses are 0.6% on Sales. The

expenditure incurred for efforts in receivable collect ion are ` 60,00,000 p.a.

So far A Ltd. had no specific arrangements to deal with export receivables, following two proposals are under

considerat ion:

(i)A non-recourse export factoring agency is ready to buy A Ltd.’s receivables by charging 2% commission. The

factor will pay an advance on receivables to the firm at an interest rate of M IBOR + 1.75% after withholding 20%

as reserve.

(ii)Insu Ltd. an insurance company has offered a comprehensive insurance policy at a premium of 0.45% of the

sum insured covering 85% of risk of non-payment . A Ltd. can assign its right to a bank in return of an advance of

75% of the value insured at M IBOR+1.50%.

Assuming that M IBOR is 6% and A Ltd. can borrow from its bank at M IBOR+2% by using exist ing overdraft facilit y

determine which of the two proposal should be accepted by A Ltd. (1 Year = 360 days).

Working Notes:

Total Annual Export Sales ` 50 crore

Cash Received in Advance (20%) ` 10 crore

Balance on credit (80%) ` 40 crore

Bad Debts 0.6% x ` 40 crore ` 0.24 crore

Average Export Debtors

` 40 crore x 78 / 360 ` 8.67 crore

Proposal I - Factoring Services

[Tutorial Note:Non-Recourse means in the event of default the loss is borne by the factor.i.e if there are bad

debts, it w ill be borne by the factor.]

Due to non-recourse factoring agreement there will be saving of bad debt . A Ltd. can choose one opt ion out of

these opt ions:

(a)Using Factoring Services (Debt Collect ion) only.

(b)Using Factoring and Finance Services i.e. above services in combinat ion of cash advance.

Since, cash advance rate is lower by 0.25% (2.00% - 1.75%), A Ltd. should take advantage of the same.

Particulars Amount (` )

Annual Factoring Commission (2% x ` 40 crore) (0.80 crore)

Saving of Administ rat ive Cost 0.60 crore

Saving of Bad Debts 0.24 crore

Interest Saving on 80% of Debtors

(` 8.67 crore x 80% * x 0.25% p.a) 0.01734 crore

Net Saving to A Ltd. 0.05734 crore

* Why 80% ? Since 20% is kept as reserve.

Proposal II - Insurance of Receivables

Particulars Amount (` )

Insurance Premium (0.45% x ` 40 crore) (0.180 crore)

Saving of Bad Debts (85% x ` 0.24 crore) 0.204 crore

Interest Saving on 75% of Debtors (0.5% x 75% x ` 8.67 crore) 0.03251 crore

Net Saving to A Ltd. 0.05651 crore

Decision: Since saving in Factoring is marginally higher it should be accepted i.e we should accept Proposal No.1.




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Mail For Getting Group LinkQUESTION NO.8Projected sales for the next year of Z Ltd. is ` 1000 Cr. The company manages it s accounts

receivables internally. Its present annual cost of sales ledger administ rat ion is ` 11 Cr. The company finances its

investment on debtors through a mix of bank credit and own long term funds in the rat io of 60: 40.Current cost of

bank credit and long term funds are 10% and 12% respect ively. The past experience indicates that bad debt

losses are 1.5% on total sales.

The company has a credit policy of 2/10, net 30.On an average, 40% of receivables are collected within the

discount period and rest are collected 70 days after the invoice date. Over the years, gross profit is maintained at

20% and the same is expected to be cont inued in future.

To enable the management focus on promot ional act ivit ies and get rid of escalat ing cost associated w it h in

house management of debtors, the company is considering the possibilit y of availing the services of Fairgrowth

Factors Ltd. for managing receivables of the company.

According to the proposal of the factor, it would pay advance to the tune of 85% of receivables deduct ing commission

with 20% interest and 81% of receivables w ith 21% interest for the recourse and non-recourse agreements

respect ively. The proposal provides for guaranteed payment within 30 days from the date of invoice. The factoring

commission would be 4% without recourse and 2% with recourse.

If the company goes for the factoring arrangement , the staff would be under burdened and concent rate more on

promot ional act ivit ies and consequent ly addit ional sales of ` 100 Cr. would be achieved. Assume that all sales of

the company are credit sales and the year is of 360 days.You are required to:

(i)Calculate cost of in house management of receivables,

(ii)Compute cost of Fair growth Factors Ltd. proposal(with recourse and without recourse),

(iii)Calculate net benefits under recourse factoring and non-recourse factoring; and

(iv)Decide the best opt ion for the company.

Solution:

Financial Analysis of Receivable M anagement Alternatives (` Crores)

(i) In-House M anagement

Cash Discount ( ` 1000 crore x 40% x 2%) 8.00

Bad Debt (` 1000 crore x 1.50%) 15.00

Administ rat ive and Selling Cost 11.00

Loss Of Increase cont ribut ion on sales ` 100 crore (0.20 - 0.015) 18.50

Cost of Investment in Receivable* 11.04

63.54

* Cost of Investment in Receivable

Average Collect ion Period (0.40 x 10 + 0.60 x 70) 46 days

Investment in Debtors (` 1000 crores x 46/360) x 0.80* * ` 102.22 crores

Cost of Investment (0.60 x 10 +0.40 x 12) 10.80%

Cost of Investment in Receivable (` 102.22 crores x 10.80%) ` 11.04 crores

* * 20% balance is gross profit margin.

(ii) Fairgrowth Factors Ltd. Proposal

W ith W ithout

Recourse Recourse


(` 1100 crores x 2.0% and 1100 crores x 4.0%) 22.00 44.00

Interest Charges

(` 1100 crores - ` 2.00 crores) 0.85 x 20% x 30/360 15.27 -

(` 1100 crores - ` 44.00 crores) 0.81 x 21% x 30/360 - 14.97

Cost of Long Term Funds Invested in Debtors

(` 1100 crores - ` 916.30* crores) 0.12 x 30/360 x 0.80 1.47 -

(` 1100 crores - ` 855.36 crores) 0.12 x 30/360 x 0.80 -____ 1.96_

38.74 60.93




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* (1100-22) x .85 =

Tutorial Note 1:1100 crore is credit sale , hence fund blocked in Debtor is ` 1100 crore.This fund blockage is

reduced by advance given by factor which is ` 916.30 crore (` 1100 crores – ̀ 22 crores)x.85 in first case.However

amount of fund st ill blocked in debtor is ` 183.7 crore(` 1100 crores – ` 916.3 crores) for which company will have

to bear cost at the rate of 12% assuming it to funded from own long term funds.

(iii) Decision Analysis:

W ith W ithout

Recourse Recourse

Benefits ( ` 63.54 crore - ` 15 crore* ) 48.54 65.04* *

Cost s 38.74 60.93

9.80_ 4.11_

* Bad Debt

* * ` 63.54 crore + 1.50 (Bad Debt Saving on addit ional Sale)

(iv)Advice: Company should go for recourse factoring.

QUESTION NO.9 A Ltd. has a total sales of ` 3.2 crores and its average collect ion period is 90 days. The past

experience indicates that bad-debt losses are 1.5% on Sales. The expenditure incurred by the firm in administering

its receivable collect ion efforts are ` 5,00,000. A factor is prepared to buy the firm’s receivables by charging 2%

Commission. The factor will pay advance on receivables to the firm at an interest rate of 18% p.a. after withholding

10% as reserve.Calculate the effect ive cost of factoring to the Firm.

Solution:

Average level of Receivables = 3,20,00,000 x 90/360 80,00,000

Factoring commission = 80,00,000 x 2/100 1,60,000

Factoring reserve = 80,00,000 x 10/100 8,00,000

Amount available for advance =` 80,00,000 - (1,60,000 + 8,00,000) 70,40,000

Factor will deduct his interest @ 18%:

360100

9018000,40,70

=` 3,16,800

Advance to be paid = ` 70,40,000 - ` 3,16,800 = ` 67,23,200

Annual Cost of Factoring to the Firm:


Interest charges (` 3,16,800 x 360/90)Total 12,67,200

19.07.200

Firm’s Savings on taking Factoring Service:

Cost of credit administ rat ion saved 5,00,000

Cost of Bad Debts (` 3,20,00,000 x 1.5/100) avoided 4.80.000

Total 9,80,000

Net cost to the Firm (` 19,07,200 - ` 9,80,000) 9,27,200

Effect ive rate of interest to the firm =200,23,67

100×200,27,913.79%

Note: The number of days in a year has been assumed to be 360 days.




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1. Factoring services will provide freedom from:-

(a)hassles of collect ing receivable (b) hassles of paying payables

(c) hassles of selling the products/ services (d) hassles of procuring raw materials.

2. Factoring is a kind of __________ service in which a business organizat ion ________

(a)management , sells its Account Recievable (b)financial, sells its Accounts Payable

(c) management , buys its Accounts Payable (d)financial, sells its Account Receivable

3. Factoring and Bill discount ing are same?

(a) False (b) True

4. "Factoring" means an arrangement between a factor and his client which includes the services to be provided

by the factor. Which of the following services are not provided?

(a) Finance (b) M aintenance of debt (c) Payment to creditors (d) Protect ion against

credit risk

5. "Factoring" means an arrangement between a factor and his client which includes at least _____ of the

following services to be provided by the factor:

. Finance . M aintenance of debt

. collect ion of debts . Protect ion against credit risk" .

(a) one (b) two (c) three (d) all

6. "Factoring means an arrangement between a factor and his client which includes at least two of the following

services to be provided by the factor:

. Finance . M aintenance of debt .

. Collect ion of debts . Protect ion against credit risk

However, the above definit ion applies only to factoring in relat ion to supply of goods and services:, which of the

following is incorrects

(a) across nat ional boundaries; (b) to t rade or professional debtors;

(c) when not ice of assignment has been given to the debtor (d) to the government

7. In a factoring t ransact ion, there are _______ part ies namelty ,__________

(a) two, the factor and the client (b) three, the factor, the client and the customers of the client

(c)two, client and the government (d) three, the factor, the t rader and the customer of the client

8. The factor,makes prepayment up to ____ per cent of the invoice value to the client .

(a)50% (b) 75% (c) 80% (d)90%

9. The two factoring charges levied are :

(a) service fee and finanace charges (b) service fee and annual maintainance charges

(c) finance charge and annual maintainance charges (d) processing fee anf service fee

10. In case of Recourse factoring, the loss arising out of irrecoverable receivables is borne by the:

(a) Factor (b)client (c) no one (d) both (a) and (b)

FACTORING-MCQ




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11. In case of Non - Recourse factoring, the loss arising out of irrecoverable receivables is borne by the:

(a) Factor (b)client (c)no one (d) both (a) and (b)

12. In advance factoring, the factor paid a pre specified port ion, ranging between __________, of the factored

receivables in advance, the balance being paid upon collect ion/ on the guaranteed payment date

(a) three-fourths to nine tenths (b) four-fifth to nine tenth

(c) three-fourth to seven tenth (d)four-fifth to seven tenth

13. Form of factoring that contains features of all factoring services, specially non-resource and advance factor-

ing is:

(a) Disclosed factoring (b) full factoring

(c)Domest ic Factoring (d)Ult imate dactoring

14. The name of the factor is disclosed in:

(a)Disclosed factoring. (b) Undisclosed faactoring

(c) Domest ic factoring (d)full factoring

15. There are usually ___ part ies involved in a cross border factoring t ransact ion.

(a)three (b) four (c) five (d)two

16. Which of the part ies are not involved in cross border factoring t ransact ionss

(a) Exporter (b) Importer (c) Government (d) Import Factor

17. Which of the following is also known as two-factor system

(a) Disclosed factoring. (b) Export / cross border factoring

(c) Domest ic factoring (d) full factoring

18.The main funct ion/ s of a factor is/ are

(a) M aintenance/ administ rat ion of sales ledger (b) Collect ion facilit y

(c) Credit Cont rol and Credit Protect ion (d) All of the above

19.Under Advisory services, which of the following services are provided?

(a) Customer's percept ion of the client 's products, changing in market ing st rategies, emerging t rends etc.

(b) Audit of the procedures followed for invoicing, delivery and dealing with sales returns.

(c) Int roduct ion to the credit department of bank/ subsidiaries of banks engaged in leasing, hire-purchase, mer-

chant banking.

(d) All of the above

20. Credit Cont rol and Credit Protect ion service is provided where debts are factored:-

(a) without recourse (b)with recourse

(c) part ially with recourse (d) none of the above.

21. Factors inhibit ing the growth of factoring in India are:

(a) Lack of credit appriasaal system (b) Lack of authent ic client database.

(c) High stamp duty (d) All of the above

22.__________ is a form of financing of receivables pertaining to internat ional t rade. It denotes the purchase of




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t rade bills/ promissory notes by a bank/ financial inst itut ion without recourse to the seller.

(a)Forfait ing (b)factoring (c) Export factoring (d)full factoring

23. In forfait ing, all risk and collect ion problems are fully the responsibilit y of the ______.

(a)purchaser (b) client (c)factor (d) debtor

24. An NBFC-Factor shall ensure that its financial assets in the factoring business const itute at least ___ per cent

of its total assets and the income derived from factoring business is not less than ___ per cent of its gross

income.

(a)50, 50 (b) 60, 50 (c) 50, 60 (d) 80, 60

25. A new company that is granted Cert ificate of Regist rat ion (CoR) by the RBI as NBFC-Factor shall commence

business within ___ months from the date of grant of CoR by the RBI.

(a)six (b) seven (c) four (d) nine

26. Every company seeking regist rat ion as NBFC-Factor shall have a minimum Net Owned Fund (NOF) of:

(a) Rs. 5 crore (b) Rs. 15 crore (c) Rs. 2.5 crore (d)Rs. 25 crore

27.An ent ity not registered with the Reserve Bank of India (RBI) may conduct the business of factoring if it is an

ent ity ment ioned in the act in:

(a) sect ion 5 (b) sect ion 6 (c)sect ion 7 (d) sect ion 3

28. A non-banking financial company engaged in factoring business shall be t reated as engaged in factor ing

business as its "principal buesinss" if it fulfils which of the following condit ions?

(a) If it s financial assets in the factoring business are more than fifty per cent . of its total assets or such per cent .

as may be st ipulated by the Reserve Bank; and

(b) If it s income from factoring business is more than fifty per cent . of the gross income or such per cent . as may

be st ipulated by the Reserve Bank.

(c) Both (a) and (b)

(d) none of the above

29. Every factor shall for the purpose of regist rat ion, file the part iculars of every t ransact ion of assignment of

receivables to the Cent ral Regist ry to be set up under Securit isat ion and Reconst ruct ion of Financial Assets and

Enforcement of Security Interest (SARFAESI) Act , 2002 within ____ from the date of such assignment or from the

date of establishment of such regist ry.

(a) 30 days (b) 2 months (c) 3 months (d)1 year

30. To remove the limitat ions and expand the factoring market in India, which of the following can be suggested?

(a) Work shop and seminars should be organized by factoring companies to enhance awareness and usefulness

of the factoring process.

(b) Incorporate a separate company which will give a t rue and fair credit appraisal report and which will cover all

aspect of client 's informat ion and their accounts.

(c) Factoring companies should expand their network and branches especially to those localit ies where small

scale units are located.


ANSWERS

1.a ; 2.d ;3.a ; 4.c ;5.b ;6.d ;7.b ;8.c ;9.a ;10.b ;11.a ;12.a ; 13.b ; 14.a ; 15.b ; 16.c ; 17.b ; 18.d ;19.d ;20.b ;21.d ;22.a ;23.a

;24.a ;25.a ;26.a ;27.a ;28.c ;29.a ; 30.d




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1.1What is lease?

Lease can be defined as a right to use equipment or capital goods on payment of periodical amount . This may

broadly be equated to an instalment credit being extended to the person using the asset by the owner of capital

goods with small variat ion.

1.2 Parties to a Lease Agreement

There are two principal part ies to any lease t ransact ion as under:

Lessor : Who is actual owner of equipment permit t ing use to the other party on payment of periodical amount .

Lessee : Who acquires the right to use the equipment on payment of periodical amount .

1.3Lease vis-a-vis Hire Purchase

Hire-purchase t ransact ion is also almost similar to a lease t ransact ion with the basic difference that the person

using the asset on hire-purchase basis is the owner of the asset and full t it le is t ransferred to him after he has

paid the agreed installments. The asset will be shown in his balance sheet and he can claim depreciat ion and

other allowances on the asset for computat ion of tax during the currency of hire-purchase agreement and thereafter.

In a lease t ransact ion, however, the ownership of the equipment always vests with the lessor and lessee only

gets the right to use the asset . Depreciat ion and other allowances on the asset will be claimed by t he lessor and

the asset will also be shown in the balance sheet of the lessor. The lease money paid by the lessee can be

charged to his Profit and Loss Account . However, the asset as such will not appear in the balance sheet of the

lessee. Such asset for the lessee is, therefore, called off the balance sheet asset .

2. TYPES OF LEASING

A lease t ransact ion has many variant s relat ing t o the t ype and nature of leased equipment , amort isat ion

period, residual value of equipment , period of leasing, opt ion for terminat ion of lease etc. Various types of

leasing t ransact ions are, therefore, operat ing in the market on the basis of these variants. The dif ferent leasing

opt ions may however, be grouped in following categories as under:

(a)Operating Lease: In this type of lease t ransact ion, the primary lease period is short and the lessor would not

be able to realize the full cost of the equipment and other incidental charges thereon during the init ial lease

period. Besides the cost of machinery, the lessor also bears insurance, maintenance and repair costs etc. The

lessee acquires the right to use the asset for a short durat ion. Agreements of operat ing lease generally provide

for an opt ion to the lessee/ lessor to terminate the lease after due not ice. These agreements may generally be

preferred by the lessee in thefollowing circumstances:

• When the long-term suitability of asset is uncertain.

• When the asset is subject to rapid obsolescence.

• When the asset is required for immediate use to t ide over a temporary problem.

Computers and other office equipments are the very common assets which form subject mat ter of many operat ing

lease agreements.

(b)Financial Lease: As against the temporary nature of an operat ing lease agreement , financial lease agreement

is a long-t erm arrangement , which is irrevocable during t he primary lease period which is generally the full

economic life of the leased asset . Under this arrangement lessor is assured to realize the cost of purchasing the

leased asset , cost of financing it and other administ rat ive expenses as well as his profit by way of lease rent

during the init ial (primary) periodof leasing itself. Financial lease involves t ransferring almost all the risks incidental

to ownership and benefits arising therefrom except the legal t it le to the lessee against his irrevocable undertaking

LEASING-THEORY




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to make uncondit ional payments to the lessor as per agreed schedule. This is a closed end arrangement with no

opt ion to lessee to terminate the lease agreement subsequent ly. In such lease, the lessee has to bear insurance,

maintenance and other related costs. The choice of asset and its supplier is generally left to the lessee in such

t ransact ions. The variants under financial lease are as under:

• Lease with purchase opt ion-where the lessee has the right to purchase the leased assets after the expiry of

init ial lease period at an agreed price.

• Lease with lessee having residual benefits-where the lessee has the right to share the sale proceeds of the

asset after expiry of init ial lease period and/ or to renew the lease agreement at a lower rental.

In a few cases of financial lease, the lessor may not be a single individual but a group of equity part icipants and

the group borrows a large amount from financial inst itut ions to purchase the leased asset . Such t ransact ion is

called ‘Leveraged lease’.

(c)Sales and Lease Back Leasing: Under this arrangement an asset which already exists and is used by the lessee

is first sold to the lessor for considerat ion in cash. The same asset is then acquired for use under financial lease

agreement from the lessor. This is a method of raising funds immediately required by lessee for working capital

or other purposes. The lessee cont inues to make economic use of assets against payment of lease rentals while

ownership vests with the lessor.

(d)Sales-Aid-Lease: When t he leasing company (lessor) enters into an arrangement with the seller, usually

manufacturer of equipment , to market the latter ’s product through its own leasing operat ions, it is called a ‘sales-

aid-lease’. The leasing company usually gets a commission on such sales from the manufacturers and increases

its profit .Apart from term loan and other facilit ies available from financial inst itut ions including banks to a promoter

to acquire equipment and other capital goods, the promoter now has an alternat ive opt ion to acquire economic

use of capital assets through leasing. The ult imate decision to either approach a financial inst itut ion or a leasing

company will, however, depend on the nature of each such t ransact ion.

3. ADVANTAGES

• The first and foremost advantage of a lease agreement is its flexibilit y. The leasing company in most of the

cases would be prepared to modify the arrangement to suit the specific requirements of the lessee. The ownership

of the leased equipment gives them added confidence to enable them to be more accommodat ive than the banks

and other financial inst itut ions.

• The leasing company may finance 100% cost of the equipment without insist ing for any init ial disbursement by

the lessee, whereas 100% finance is generally never allowed by banks/ financial inst itut ions.

• Banks/ financial inst itut ions may involve lengthy appraisal and impose st ringent terms and condit ions to the

sanct ioned loan. The process is t ime consuming. In cont rast leasing companies may arrange for immediate

purchase of equipment on mutually agreeable terms.

• Lengthy and t ime consuming documentat ion procedure is involved for term loans by banks/ inst itut ions. The

lease agreement is very simple in comparison.

• In short -term lease (operat ing lease) the lessee is safeguarded against the risk of obsolescence. It is also an

ideal method to acquire use of an asset required for a temporary period.

• The use of leased assets does not affect the borrowing capacity of the lessee as lease payment may not require

normal lines of credit and are payable from income during the operat ing period. This neither affects the debt

equity rat io or the current rat io of the lessee.

• Leased equipment is an ‘off the balance sheet ’ asset being economically used by the lessee and does not affect

the debt posit ion of lessee.

• By employing ‘sale and lease back’ arrangement , the lessee may overcome a financial crisis by immediately

arranging cash resources for some emergent applicat ion or for working capital.

• Piecemeal f inancing of small equipments is convenient ly possible through lease arrangement only as deb




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financing for such items is impract icable.

• Tax benefits may also somet imes accrue to the lessee depending upon his tax status.

4.DISADVANTAGES

• the lease rentals become payable soon after the acquisit ion of assets and no moratorium period is permissible

as in case of term loans from financial inst itut ions. The lease arrangement may, therefore, not be suitable for

set t ing up of the new projects as it would entail cash out flows even before the project comes into operat ion.

• The leased assets are purchased by t he lessor who is the owner of equipment . The seller ’s warrant ies for

sat isfactory operat ion of the leased assets may somet imes not be available to lessee.

• Lessor generally obtain credit facilit ies from banks etc. to purchase the leased equipment which are subject to

hypothecat ion charge in favour of the bank. Default in payment by the lessor may somet imes result in seizure of

assets by banks causing loss to the lessee.

• Lease financing has a very high cost of interest as compared to interest charged on term

loans by financial inst it ut ions/ banks.Despite all these disadvantages, the flexibilit y and simplicit y offered by

lease finance is bound to make it popular. Lease operat ions will find increasing use in the near fut ure.

5. EVALUATION OF LEASE

The most important part in lease financing is its evaluat ion both from the point of view of Lessee and Lessor.

5.1From Lessee’s Perspective

A lease can be evaluated either as an investment decision or as a financing means. If an investment decision

has already been made, a firm (lessee) has to evaluate whether it w ill purchase the asset equipment or acquire

it on lease basis. The lease rentals can be taken as interest on debt . Thus, leasing in essence is alternat ing

source of financing to borrowing. The lease evaluat ion thus is debt financing versus lease financing.

There are three methods of evaluat ing a leasing proposal viz. Present Value analysis, Internal Rate of Return

analysis, and the Bower Herringer Williamson method.

5.1.1Present Value Analysis (Net Advantage of Leasing)

In this method, the present value of the annual lease payments (tax adjusted) is compared with that of the

annual loan repayments adjusted for tax shield on depreciat ion and interest , and the alternat ive which has the

lesser cash out flow will be chosen.

Otherwise we can also define it as Net Advantage of Leasing (NAL) as follows:

NAL = PV of Cost of Owning - PV of Leasing

If NAL is posit ive, we should opt for leasing otherwise borrowing and buying opt ion.

5.1.2 Internal rate of return analysis

Under this method there is no need to assume any rate of discount . To this extent , this is different from the

former method where the after-tax cost of borrowed capital was used as the rate of discount . The result of this

analysis is the after-tax cost of capital explicit in the lease which can be compared with that of the other available

sources of finance such as a fresh issue of equity capital, retained earnings or debt . Simply stated, this method

seeks to establish the rate at which the lease rentals, net of tax shield on depreciat ion are equal to the cost of

leasing.

5.1.3 Bower-Herringer-W illiamson M ethod

This method segregates the financial and tax aspects of lease financing. If the operat ing advantage of a lease

is more than its financial disadvantage or vice-versa lease will be preferred.

The procedure of evaluat ion is briefly as follows:

1.Compare the present value of debt with the discounted valueof lease payments(gross),t he rat e of discount

being the gross cost of debt capital. The net present value is the financial advantage (or disadvant age).

2.Work out the comparat ive tax benefit during theperiodanddiscount it atan appropriate

cost of capital. The present value is the operat ing advantage (or disadvantage) of leasing.




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3.If the net result is an advantage, select leasing.

5.1.4 Selection of Discount Rate

While examining the proposals of Lease Vs. Borrowing and Buying the select ion of discount ing rate for discount ing

is an issue. Related cash flows can be discounted both at the rate of Post Tax Cost of Debt and Cost of Capital and

final decision will be same. However, since leasing is subst itute for borrowing opt ion, post-tax cost of debt is a

good opt ion for discount ing.

5.2 From Lessor’s Perspective

The leasing evaluat ion from view point of Lessor in fact a Capital Budget ing Decision involving financing of

asset out of the funds acquired from various sources involving some costs.

Accordingly, Lessor would like to invest only if it has posit ive return. In other words, the Lessor would be ready for

the financing proposal if the return from it is more than cost of funds involved.

Like t radit ional capital budget ing decision, t he Lessor can accept the proposal of financing on the follow ing

methods of evaluat ion:

(i)Net Present Value (NPV) M ethod: The Lessor would accept the proposal of financing the asset if NPV of the

same is zero or more. If it is negat ive, then it would not be accepted as it would not be beneficial to accept the

proposal.

(ii)Internal Rate of Return (IRR) M ethod: In terms of IRR M ethod the financing proposal should be accepted

only if computed IRR of cash flows is more than the required cut-off rate or Cost of Capital or Weighted Average

Cost of Capital (WACC).

Like Capital Budget ing Decision the various types of Cash flows involved in financing decisions are as follows:

(a)Initial Cash Outflow: Like in Capital Budget ing decision, the init ial cash out flow in financing proposal involves

the Purchase Price of M achine and incidental expenses thereto.

(b)Annual Cash Flows: The Annual Cash Flow shall be accrued in the form of Annual Lease Rental adjusted in

light of tax benefits on Depreciat ion and tax liabilit y. Accordingly, it can be computed as follows:

= (Lease Rental - Depreciat ion) X (1 - t ) + Depreciat ion

(c)Terminal Cash Flows: Just like in the terminal year of a project in financing proposal, the terminal cash flow

involved is disposal/ salvage value of the asset financed net of Tax Adjustment on Short Term Capital Loss or

Gain, if any.

In case of NPV method, the above ment ioned cash flows are discounted at Cost of Capital and in IRR M ethod, the

Cut Off rate is computed from these Cash Flows and compared with Cost of Capital or WACC.

6. BREAK EVEN LEASE RENTAL (BELR)

Break-Even Lease Rental can be viewed both from the perspect ive of lessee as well as the lessor.

6.1 Break Even Lease Rental (BELR) from Lessee’s point of view

From the point of view of lessee, the BELR is the rental at which the lessee is indifferent between borrowing

and buying opt ion and lease financing opt ion. In other words, he can opt for any one opt ion. At this rental the Net

Advantage of Leasing (NAL) will be zero. It can also be defined as maximum lease rental the lessee w ould be

willing to pay.

In case if BELR is less than the actual lease rent payable, the lease opt ion would not be viable.




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6.2 Break Even Lease Rental (BELR) from Lessor’s point of View

From the lessor ’s view point , BELR is the minimum (floor) lease rental, which he should accept . In this case also

NAL should be zero. Any lease rent below BELR should not be accepted. It is to be noted that while comput ing

NAL, the over all cost of capital of the firm should be used.

7. CROSS-BORDER LEASING

Cross-border leasing can be considered as an alternat ive to equipment loans in some emerging foreign market ,

where finance leases are t reated as condit ional sales agreements. The only difference between internat ional

leasing and loans will be the documentat ion, with down payments, payment st reams, and lease-end opt ions the

same as offered under Equipment Loans to Foreign Buyers. The various kinds of leasing arrangements available

in the U.S. market are not yet feasible in most cases for cross-border leasing t ransact ions. There are however,

at tempts to develop more flexible internat ional leasing st ructures for export financing. Operat ing leases may be

feasible for exports of large equipment with a long economic life relat ive to the lease term.

Cross-border leasing is a leasing arrangement where lessor and lessee are situated in two different count ries.

This raises significant addit ional issues relat ing to tax avoidance and tax shelters.

Cross-border leasing has been widely used in some European count ries, to arbit rage the difference in the tax

laws of different count ries. Typically, this rests on the premise that , for taxpurposes, some assign ownership and

the at tendant depreciat ion allowances to the ent ity that has legal t it le to an asset , while others assign it to the

ent ity that has the most of the use (legal t it le being only one of several factors taken into account ). In these

cases, with sufficient ly long leases (often 99 years), an asset can end up with two effect ive owners, one each in

different count ries, this is often referred to as a double-dip lease.

Often the original owner of an asset is not subject to taxat ion in any count ry and therefore not able to claim

depreciat ion. The t ransact ion often involves an ent ity selling an asset (such as sewerage system or power plant )

to an investor (who can claim depreciat ion), and long-t erm leasing it right back (often referred t o as a sale

leaseback).

Leasing techniques had been used for financing purposes for several decades throughout the world. The pract ice

was developed as a method of financing aircraft . Several airlines ent it ies in the early 1970s were unprofitable

and very capital intensive. These airlines had no need for the depreciat ion deduct ions generated by their aircraft

and were significant ly more interested in reducing their operat ing expenses. A very prominent bank purchased

aircraft and leased them to the airlines and because the bank was able to claim depreciat ion deduct ions for

those aircraft , the bank was able to offer lease rates that were significant ly lower than the interest payments

that airlines would have to pay on an aircraft purchase loan (and most commercial aircraft flying today are

operated under a lease). In the United States, this spread into leasing the assets of U.S. ent it ies and governmental

ent it ies and eventually evolved into cross-border leasing.

One signif icant evolut ion of the leasing indust ry involved t he collateralizat ion of lease obligat ions in sale

leaseback t ransact ions. For example, an ent ity would sell an asset t o a bank, t he bank would require lease

payment and give an ent ity an opt ion to repurchase the asset , the lease obligat ions were low enough (due to the

depreciat ion deduct ions the banks were now claiming) so that the ent ity could pay for the lease obligat ions and

fund the repurchase of the asset by deposit ing most but not all of the sale proceeds in an interest bearing

account . This resulted in the ent ity having pre-funded all of its lease obligat ions as well as its opt ion to repurchase

the asset from the bank for less than the amount received in the init ial sale of the asset so the ent ity would be

left w ith addit ional cash after having pre-funded all of its lease obligat ions.

This gave the appearance of ent it ies entering into leasing t ransact ions with banks for a fee. By the late 1990s

many of such leasing t ransact ions were with ent it ies in Europe. However, in 1999 cross border leasing in the

United States was “ stopped” by the effect ive shutdown of LILOs (lease-in/ lease outs). LILOs were significant ly




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more complicated than the typical lease where an owner (for example) would lease an asset to a bank and then

lease it back from the bank for a shorter period of t ime.

Cross-border leasing has been in pract ice as a means of financing infrast ructure development in emerging

nat ions. Cross-border leasing may have significant applicat ions in financing infrast ructure development in emerging

nat ions such as rail and air t ransport equipment , telephone and telecommunicat ions equipment and assets

incorporated into power generat ion and dist ribut ion systems and other projects that have predictable revenue

st reams.

A major object ive of cross-border leases is to reduce the overall cost of financing through ut ilizat ion by the lessor

of tax depreciat ion allowances to reduce its taxable income. The tax savings are passed through to t he lessee as

a lower cost of f inance. The basic prerequisites are relat ively high tax rates in t he lessor ’s count ry liberal

depreciat ion rules and either very flexible or very formalist ic rules governing tax ownership.

Other important object ives of cross border leasing include the following:

• The lessor is often able to ut ilize nonrecourse debt to finance a substant ial port ion of the equipment cost . The

debt is secured by among other things, a mortgage on the equipment and by an assignment of the right to receive

payments under the lease.

• Also, depending on the st ructure, in some count ries the lessor can ut ilize very favourable “ leveraged lease”

financial account ing t reatment for the overall t ransact ion.

• In some count ries, it is easier for a lessor to repossess the leased equipment following a lessee default because

the lessor is an owner and not a mere secured lender.

• Leasing provides the lessee with 100% financing.

While details may differ from one t ransact ion to another, most leasing st ructures are essent ially similar and

follow the “ sale-leaseback” pat t ern. The principal players are (i) one or more equity investors; (ii) a special

purpose vehicle formed to acquire and own the equipment and act as the lessor; (iii) one or more lenders, and (iv)

the lessee. The lease itself is a “ t riple-net lease” under which the lessee is responsible for all costs of operat ion,

maintenance and insurance.

In many t ransact ions, the lessee’s fixed payment obligat ions are prefunded or “defeased” through an up-front

payment (in an amount equal to the present value of the fixed payment obligat ions) to a financial ent ity that

assumes such obligat ions. The benefits of defeasance include (i) the lessee can lock in its financial savings by

making the defeasance payment ; (ii) by rout ing the lease payments through the defeasance ent ity’s jurisdict ion,

withholding taxes applicable to lease payments in the lessee’s jurisdict ion may possibly be avoided; (iii) defeasance

serves to some extent as a credit enhancement technique for the lessor, and (iv) defeasance may eliminate or

reduce currency risk exposure.

In order for the lessor to obtain the tax benefits associated with equipment leasing, most count ries require that

the lease be t reated as a “ t rue lease” for t ax purposes, as opposed to a condit ional sale or other secured

financing arrangement . This object ive generally can be sat isfied if the lessor has “ tax ownership” of the leased

equipment.

Each count ry applies different rules for determining whether the party act ing as lessor under a cross-border

lease is the “owner” of the leased asset for tax purposes and is thereby ent it led to claim tax allowances. In the

United States and some other count ries, the principal focus is on whether the lessor possesses substant ially all

att ributes of economic ownership of the leased asset . Other count ries such as the United Kingdom and Germany

apply more formalist ic property law concepts and focus primarily on the locat ion of legal t it le, alt hough these

count ries usually also require that the lessor have some att ributes of economic ownership or, at least , that the




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lessee have only a minimal economic interest in the equipment . In Japan, ownership of legal t it le is essent ial, but

the lessor is only required under current law to obtain nominal incidents of economic ownership (all that is

required is that the lease will provide a return of the equity investment plus a pre-tax profit of 1% of equipment

cost ). While Japan does have detailed tax lease guidelines, these guidelines are designed primarily to circumscribe

the tax benefits available to the lessor in a cross-border lease to prevent undue tax deferral; they do not require

the lessor to have a significant economic interest in the leased equipment .

The non-tax issues associated with cross-border leasing can best be described by reference to the various

st ructural risks that may arise in a given t ransact ion and must be addressed in the documentat ion.

8. REGULATORY ASPECTS OF LEASING

A Leasing Company is a Non-Banking Financial Company as per the FAQs given in the RBI Website https:/ /

www.rbi.org.in. So, in a way, it has to get itself registered with RBI. The reason is that in terms of Sect ion 45-IA

of the RBI Act , 1934, no Non-banking Financial company can commence or carry on business of a non-banking

financial inst itut ion without obtaining a cert ificate of regist rat ion from the RBI.

Further, as per Sect ion 45-IA of the said Act , no non-banking financial company shall commence or carry on the

business of a non-banking financial inst itut ion without -

(a) obtaining a cert ificate of regist rat ion issued under this Chapter; and

(b) having the net owned fund of twenty-five lakh rupees or such other amount , not exceeding two hundred lakh

rupees, as the RBI may, by not ificat ion in the Official Gazette, specify.

M eaning of “net owned fund”

It means-

(a) the aggregate of the paid-up equity capital and free reserves as disclosed in the latest balance-sheet of the

company after deduct ing therefrom- (i) accumulated balance of loss; (ii) deferred revenue expenditure; and (iii)

other intangible assets; and

(b) further reduced by the amounts represent ing investments of such company in shares of - (i) it s subsidiaries;

(ii) companies in the same group; (iii) all other non-banking financial companies;

Further, an Equipment Leasing Company has been an eligible NBFC for the purpose of acceptance of deposits

by NBFCs defined in paragraph 2(1) of the Non-Banking Financial Companies Acceptance of Public Deposits

(Reserve Bank) Direct ions, 1998. As per the said direct ions, Equipment Leasing (EL) means any company which is

a financial inst itut ion carrying on as its principal business, the act ivity of leasing of equipment .




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EVALUATION FROM THE POINT OF VIEW OF LESSEE & BORROWER

QUESTION NO. 1A ABC Ltd. is considering to acquire an addit ional computer. It has two opt ions :

(i) To purchase the computer for ` 22,00,000 and

(ii) To lease the computer on an annual rental (payable at the end of the years) of `5,00,000 plus 10% of gross

revenue from t ime services. An amount of `6,00,000 is also payable at the end of years 3.

The revenues from computer are est imated at ` 22,50,000, ̀ 25,00,000 and ̀ 27,50,000 for 3 years. The computer

salvage value is ` 10,00,000 at the end of 3rd year.

Annual operat ing cost (excluding depreciat ion and lease rent ) is est imated at ` 2,00,000 per annum and an

addit ional revenue expense of ` 2,00,000 is payable for t raining in the beginning of the 1st year (both these costs

are to be borne by the lessor in case of lease).

Funds for purchase are to be acquired at the rate of 16% and are repayable ` 5,00,000, ` 8,50,000 and ` 8,50,000

at the end of 3 years respect ively.

Firm pays tax at the rate of 50% and provides depreciat ion at st raight line method.

The management approaches you to advice,which alternat ive would be recommend and why ?

QUESTION NO.1BBright Limited is considering to acquire an addit ional sophist icated computer to augment its

t ime-share computer services to its clients. Its has two opt ions :Either,

(a)to purchase the computer at a cost of ` 44,00,000 Or,(b)to take the computer on lease for 3 years from a

leasing company at an annual lease rental of ` 10 lacs plus 10% of the gross t ime-share service revenue. The

agreement also requires an addit ional payment of ` 12 lacs at the end of the third year. Lease rentals are payable

at the year end and the computer reverts back to lessor after period of cont ract .The company est imates that the

computer will be worth ` 20 lacs at the end of the third year.The Gross revenue to be earned are as follows :—

Year ` in lacs

1 45

2 50

3 55

Annual operat ing cost (excluding depreciat ion/ lease rental) are est imated at ` 18 lacs with an addit ional revenue

cost of ` 2 lacs for start up and t raining at the beginning of the first year. These costs are to be borne by the

lessee in case of lease arrangement also. The company proposes to borrow @ 16% interest to finance the

purchase of the computer and the repayments are to be made as per the following schedule :—

Year Repayment of Total

end Principal Interest

` ` `

1 10,00,000 7,04,000 17,04,000

2. 17,00,000 5,44,000 22,44,000

3. 17,00,000 2,72,000 19,72,000

For the purpose of this computat ion assume that the company uses the st raight line method of depreciat ion on

assets and pays 50% tax on its income.You are required to analyse and recommend to the company which of the

two opt ions is better. [PV factor @ 8% for year 1 (0.926), year 2 (0.857), year 3 (0.794) and @ 16% for year 1

(0.862), year 2 (0.743) and year 3 (0.641)].

Solution:

Additional Analysis:

This quest ion is similar to the Quest ion No. 1 solved in class.The only difference is that in Q.No. 1 Operat ing cost

LEASING-PRACTICAL




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and Training cost were borne by Owner i.e Lessor and Borrower,but in this quest ion it is borne by Users i.e Lessee

and Borrower.

Now since it is borne by both Lessee and Borrower it become a common item and hence can be ignored.

Working notes:

Depreciat ion p.a. = (` 44 Lakhs – ` 20 Lakhs) / 3 years = ` 8 Lakhs p.a.

Tax advantage on depreciat ion p.a. = ` 8 Lakhs x 0.50 = ` 4 Lakhs p.a.

Tax advantage on interest paid = 16% (1 – 0.50) =8%

Present Value of cash outflow under Leasing Alternative :

Year Lease 10% of Tax Saving Total Net cash PVF Total PV

Rent Gross @ 50% Revenue outflow @ 8%

1 10,00,000 4,50,000 14,50,000 7,25,000 7,25,000 0.926 6,71,350

2 10,00,000 5,00,000 15,00,000 7,50,000 7,50,000 0.857 6,42,750

3. 10,00,000 5,50,000 27,50,000 13,75,000 13,75,000 0.794 10,91,750

Lump sum payment 12,00,000

Total Present Value 24,05,850

Present value of Cash outflow if Computer is bought

Year Initial Interest Total Tax Tax Net cash PVF Total PV

payment @ 16% advantage saving Outflow factor `

on on @ 8%

Interest Dep

1 10,00,000 7,04,000 17,04,000 3,52,000 4,00,000 9,52,000 0.926 8,81,552

2 17,00,000 5,44,000 22,44,000 2,72,000 4,00,000 15,72,000 0.857 13,47,204

3. 17,00,000 2,72,000 19,72,000 1,36,000 4,00,000 14,36,000 0.794 11,40,184

(20,00,000) 0.794 (15,88,000)

Salvage ________

Total Present Value 17,80,940

Decision: The present value cash-out flow is less by ` 6,24910 (i.e., 24,05,850 – 17,80,940) if the comput re is

bought . Therefore, purchase of computer is suggested.

Internal Rate Of Return (IRR) IN CASE OF LESSOR

QUESTION NO. 2Armada Leasing Company is considering a proposal to lease out a school bus. The bus can be

purchased for ̀ 5,00,000 & in turn, be leased out at ̀ 1,25,000 per year for 8 years with payments occurring at the

end of each year:

(i)Estimate the internal rate of return for the company assuming tax is ignored.

(ii)What should be the yearly lease payment charged by company in order to earn 20% rate of return

(iii)Calculate the annual lease rent to be charged so as to amount to 20% after tax rate of return, based on the

following assumpt ions:

(a)Tax rate is 40%;(b)Straight line depreciat ion; (c)Annual expenses of ̀ 50,000;(d)Resale(Salvage) value ̀ 1,00,000.

Breakeven Lease Rental FOR LESSEE

QUESTION NO. 3ABeta Ltd. is considering the acquisit ion of a personal computer cost ing Rs. 50,000. The effec-

t ive life of the computer is expected to be five years. The company plans to acquire the same either by borrowing

` 50,000 from the bankers at 15% interest per annuam or by lease. The company wants to know the lease rentals

to be paid annually which will match the loan opt ion. The following informat ion is provided to you:

(a)The pricinpal amount of the loan will be paid in five annual equal installments.




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(b)Interest , lease rentals, principal repayment is to be paid on last day of each year.

(c)The full cost of the computer will be writ ten off over the effect ive life of computer on a st raight -line basis and

the same will be allowed for tax purposes.

(d)The company’s effect ive tax rate is 40% and the after tax cost of capital is 9%.

(e)The computer will be sold for ` 1,700 at the end of the 5th year. The commission on such sales is 9% on the

sale value and the same will be paid.

You are required to compute the annual lease rentals payable by Beta Ltd. which will result in indifference to

the loan opt ion.

QUESTION NO.3BA company is planning to acquire a machine cost ing `500,000. Effect ive life of the machine is

5 years. The company is considering two opt ions. One is the purchase the machine by lease and the ot her is to

borrow `5,00,000 from it s bankers at 10% interest p.a. The Principal amount of loan will be paid in 5 equal

installments to be paid annually. The machine will be sold at `50,000 at the end of 5th year. Following further

informat ions are as given :

(a)Principal, interest , lease rentals are payable on the last day of each year.

(b)The machine will be fully depreciated over its effect ive life.

(c) Tax rate is 30% and after tax Discount Rate to be used for the above analysis is 8%

Compute the lease rentals payable which will make the firm indifferent to the loan opt ion.

Solution:

(a) Borrowing Option :

Annual Principal Amount =5

000,00,5= ` 1,00,000/ - ;

Annual Depreciat ion = 5

000,00,5= ` 1,00,000/ -

Additional Analysis: Why Sale Value of ` 50000 has not been considered? Since it is writ ten in the quest ion that

machine will be fully depreciated over its effect ive life. It means full `5,00,000 should be available for deprecia-

t ion .

Present Value of Outflow under Borrowing (Loan Option)

Year Interest (1 – tax) Principla Amt. Tax Saving on Dep. Salvage Value

1 35000 1,00,000 (30,000) -

2 28000 1,00,000 (30,000) -

3 21000 1,00,000 (30,000) -

4 14000 1,00,000 (30,000) -

5 7000 1,00,000 (30,000) (35,000)

Calculation of Net Cash Flow :

Year NCF PVF@8% Present Value

1 1,05,000 0.926 97,230

2 98,000 0.857 83,986

3 91,000 0.794 72,254

4 84,000 0.735 61,740

5 42,000 0.681 28,602

Present Value of Total Outflows 3,43,812

Working Note :Profit / Loss on Sale M achine :

Original Cost 50,00,000

Less: Depriciat ion 50,00,000

Writ ten Down Value at the end of 5 year 0




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Less : Sale Value 50,000

Profit on Sale 50,000

Tax @ 30% to be paid on profit 15000

Therefore Salvage Value Adjusted For Tax = ` 50,000 - ` 15,000= ` 35,000

OR

Since ent ire amount has been depriciated, full sale amount of ` 50,000 will represent profit . Hence amount

Received Net of Tax = ` 50,000 - ` 15,000 = ` 35,000

Let the Lease Rentals be X which will make the firm indifferent to the loan opt ion:

Therefore we have,

X (1-tax) x PVAF (K%,n years) = 343812

X (1-.30) x PVAF (8%,5years) = 343812

X (1-.30) x 3.993 = 343812 X = 123006 (approx)

QUESTION NO.3CThe following investment proposal is available to XYZ Ltd.

Init ial Investments ` 18 crores

Life of M achine 3 years

Salvage value of machine after 3 year ` 180 lakh

Depreciat ion (WDV M ethod) 40 %

From above data compute the BELR, if other opt ion of borrowing at a rate of interest of 17% p.a is available.

Further, you may also assume that the cost of capital to the company is 12% and applicable tax rate is 35%. Use

Equated Annual Instalment M ethod.

Solution:

Evaluation of Lease Option

Let Lease Rental be ` X

Discount Rate = 17% (1-0.35) = 11.05%

Year Annual Lease Rent(1-t) PVAF @ 11.05% Present Value of Cash Outflow

1-3 x (1-0.35) = 0.65x 2.442 1.5873x

Evaluation of Loan Option (Amt. in Lakhs)

Year Interest Tax Saving Principal Salvage Net PVF Present

(1-t) on Dep. Repayment Value Cash @11.05% Value

Adj. for tax Outflow

1 198.90 (252) 508.48 -455.38 0.900 409.84

2 142.714 (151.20) 594.92 -586.434 0.811 475.60

3 76.622 (90.72) 696.60 (253.08) 429.422 0.730 313.48

Present Value of Cash Out flow 1198.92

Working Notes:

(1)Calculation of Equal Annual Installment

EAI = `1800 Lakhs/2.210 = ` 814.48 Lakhs

(2)Bifurcation Table (Amt. in Lakhs)

Year Opening Installment Interest Principle Closing Balance

Balance Paid @ 17% Repayment

1 1800 814.48 306 508.48 1291.52

2 1291.52 814.48 219.56 594.92 696.60

3 696.60 814.48 117.88 (BF) 696.60 -

(3)Calculation of Tax Saving on Depreciation (Amt. in Lakhs)




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Year Opening Depreciation Closing Tax Saving

WDV WDV @ 35%

1 1800 720 1080 252

2 1080 432 648 151.20

3 648 259.20 388.80 90.72

(4)Calculation of Salvage Value Adjusted for Tax (Amt. in Lakhs)

Cost of M achine 1800

(-) Depreciat ion t ill date 1411.20

Book Value 388.80

(-) Salvage Value 180

Loss on Sale 208.80

Tax Saving on Loss 73.08

Salvage Value adj. for tax = 180+73.08= ` 253.08 Lakhs

Calculat ion of BELR

X = 1198.92 Lakhs /1.5873 OR X = ` 755.32 Lakhs

QUESTION NO.3DM / s ABC Ltd. is to acquire a personal computer with modem and a printer. Its price is ̀ 60,000.

ABC Ltd. Can borrow `60,000 from a commercial bank at 12% interest per annum to finance the purchase. The

principal sum is to be repaid in 5 equal year end installments. ABC Ltd. can also have the computer on lease for

5 years.The firm seeks your advice to know the maximum lease rent payable at each year end. Consider the

following addit ional informat ion:

(i)Interest on bank loan is payable at each year end.

(ii)The full cost of the computer will be writ ten off over the effect ive life of computer on st raight line basis. This

is allowed for tax purposes.

(iii)At the end of year 5, the computer may be sold for `1,500 through a second hand dealer, who will charge 8%

commission on the sale proceeds.

(iv)The company’s effect ive tax rate is 30%.

(v)The cost of capital is 11%.

Suggest the maximum annual lease rental for ABC Ltd. PV Factor at 11%

Year 1 2 3 4 5

PVF 0.901 0.812 0.731 0.659 0.593

Solution:

(a) Workings:

(i)Annual loan repayment : =5

000,60= ` 12,000

(ii)Residual sale value at year 5 1,500

(-) Commission at 8% 1,20_

Profit on sale 1380

(-) Tax @ 30% 414_

Net cash flow (` 1,380 - ` 414)= `966

(iii) Net cash outflow under loan option –

Year(`) 1(`) 2(`) 3(`) 4(`) 5(`) Total

Principal repayment 12,000 12,000 12,000 12,000 12,000 60,000

Payment of Interest 7,200 5,760 4,320 2,880 1,440 21,600

(-) Tax Savings @ 30%




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on depreciat ion (3,600) (3,600) (3,600) (3,600) (3,600) (18,000)

Tax savings on Interest (2,160) (1,728) (1,296) (864) (432) (6,480)

Net out flow 13,440 12,432 11,424 10,416 9,408 57,120

Discount factor at 11% 0.901 0.812 0.731 0.659 0.593 3.696

PV of cash out flow 12,109 10,095 8,351 6,864 5,579 42,998

Less: PV of Salvage Value ` 966×0.593 (573)__

PV of Net Cash out flows 42,425_

Calculation of Annual Lease Rental:

Let L be the lease rental.

Therefore to match loan Opt ion with Lease Opt ion, Present Value Of Out flows under Lease Opt ion must also be

`42,425.

Therefore we have : L 0.70 3.696 = `42424 L = `16400

Hence, Annual Lease Rentals payable by Beta Ltd. should be `16400

Different Plan Under Lease Rentals

QUESTION NO. 4AThe following data relate to the TATA Leasing Ltd.(Lessor):

(i)Investment Out lay / Cost of Asset = 100 lakh(ii)Lessor ’s Desired Return= 20%

(iii)Lease term = 5 years. (iv)Residual value (after primary period) = Nil

Compute Annual Lease Rentals (or Ballooned Payment in case of d ) under the following alternat ives:

(a)Equal Annual Plan

(b)Stepped up Plan (15% increase per annum)

(c)Deferred Plan (deferment period of 2 years)

(d)Ballooned Plan (annual rental of `10 lakh for year 1-4)

QUESTION NO.4BAssuming lease amort ised in 5 years, calculate rental st ructure from the following :

Investment Out lay ` 100 Lakhs

Pre Tax Rate 20%

Scrap Value Nil

Schemes

(a)Equal Annual Plan

(b)Stepped Up Plan (15% increase per annum)

(c)Balloon Plan (he pays Rs. 400,000 in the fourth year and no payments in first three years)

(d)Deffered plan (deferment of 2 years).Calculate Lease Rentals.

Soluton: Self

(a) Equal Annual Plan :Lease Rental = `33.434 lakhs per year.

(b) Stepped Up Plan (15% increase per annum) :Lease Rental = `26.09 lakhs per year.

(c) Balloon Plan (he pays ` 400,000 in the fourth year)

100 = 4 x PVF(20%,4yrs) + Balloon Lease Rent x PVF(20%,5yrs)

Balloon Lease Rent = `243.96 lakhs per year

(d) Deffered plan (deferment of 2 years): Lease Rental = 68.35 lakhs per year.

Equated Annual Loan Inclusive Of Interest

QUESTION NO. 5AAgrani Ltd. is in the business of manufacturing bearings. Some more product lines are being

planned to be added to the exist ing system. The asset required may be brought or may be taken on lease. The

cost of machine is `40,00,000 having a useful life of 5 years with the salvage value of ` 8,00,000. The full

purchase value of machine can be financed by 20% loan repayable in five equated instalments falling due at the




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end of each year. Alternat ively, the machine can be procured on a 5 years lease, year-end lease rentals are `

12,00,000 per annum. The Company follows the writ ten down value method of depreciat ion at the rate of 25%.

Company’s tax rate is 35 per cent and cost of capital is 16 per cent .

(i)Advise the company which opt ion it should choose - lease or borrow.

(ii)Evaluate the proposal from the lessor ’s point of view examining whether leasing the machine is financially

viable at 14% cost of capital (Detailed working notes should be given. Calculations can be rounded off to ̀ lakhs)

QUESTION NO.5BEngineers Ltd. is in the business of manufacturing nut bolts. Some more product lines are being

planned to be added to the exist ing system. The machinery required may be bought or may be taken on lease. The

cost of machine is ` 20,00,000 having a useful life of 5 years w it h t he salvage value of ` 4,00,000. The full

purchase value of machine can be financed by bank loan at the rate of 20% interest repayable in five equal

instalments inclusive of interest falling due at the end of each year. Alternat ively, the machine can be procured on

a 5 years lease, year end lease rentals being ` 6,00,000 per annum. The Company follows the writ ten down value

method of depreciat ion at the rate of 25 per cent . Company’s tax rate is 35 per cent and cost of capital is 14 per

cent .

(i)Advise the company which opt ion it should choose – lease or borrow.

(ii)Assess the proposal from the lessor ’s point of view examining whether leasing the machine is financially

viable at 14 per cent cost of capital.

Detailed working notes should be given.(i)

Solution:

Present Value of Cash Outflows under Leasing Alternatives :

Year-end Lease Rent after taxes p.a PVAF@13% Present Value

1-5 6,00,000(1-.35) = ` 3,90,000 3.517 `13,71,630

Present Value of Cash Outflows under Borrowing Alternatives :

Year Interest (1 – tax) Principal Tax Saving on Dep. Salvage Value

1 260000 2,68,673 (1,75,000)

2 225072 3,22,408 (1,31,250)

3 183160 3,86,889 (98,438)

4 132864 4,64,267 (73,828)

5 7209 15,57,763 (55,371) (4,00,000)+(26113.15)

Hint:26113.15=Tax Saving On Loss Of Sale of Asset = (4,74,609 - 4,00,000) X 35%


Year NCF PVF@13% Present Value

1 3,53,673 0.885 3,13,001

2 4,16,230 0.783 3,25,908

3 4,71,611 0.693 3,26,826

4 5,23,303 0.613 3,20,785

5 1,48370 0.543 80564.82


Working Notes :

(1) Equal Annual Loan inclusive of Interest :

Equal Annual Loan inclusive of Interest =Years) (20%,5 PVAF

20,00,000=

2.991

20,00,000 = ` 6,68,673

(2) Schedule of Depreciation

Year Opening WDV Depreciation Closing WDV

1 20,00,000 5,00,000 15,00,000

2 15,00,000 3,75,000 11,25,000




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3 11,25,000 2,81,250 8,43,750

4 8,43,750 2,10,938 6,32,812

5 6,32,812 1,58,203 4,74,609

(3) Bifurcation Table

Year Opening Interest@ Repayment Closing Principal

end Balance 20% Balance Amount

1 20,00,000 4,00,000 6,68,673 17,31,327 2,68,673

2 17,31,327 3,46,265 6,68,673 14,08,919 3,22,408

3 14,08,919 2,81,784 6,68,673 10,22,030 3,86,889

4 10,22,030 2,04,406 6,68,673 5,57,763 4,64,267

5 5,57,763 1,10,910* 6,68,673 0 5,57,763

* Balancing Figure

(4)Discounting Factor:Cost of finance 20% - Tax 35% = 13%

Advice:Company is adviced to borrow & buy & not to go for leasing as NPV of cash out flows is lower in case of

buying alternat ive.

(ii) Evaluation from Lessor’s Point of View :

(1) (2) (3) (4) (5)

Lease Rent Received 6,00,000 6,00,000 6,00,000 6,00,000 6,00,000

Less : Depreciat ion 5,00,000 3,75,000 2,81,250 2,10,938 1,58,203

EBT 1,00,000 2,25,000 3,18,750 3,89,062 4,41,797

Less : Tax @ 35% 35,000 78,750 1,11,563 1,36,172 1,54,629

EAT 65,000 1,46,250 2,07,187 2,52,890 2,87,168

Add : Depreciat ion 5,00,000 3,75,000 2,81,250 2,10,938 1,58,203

Cash Inflows 5,65,000 5,21,250 4,88,437 4,63,828 4,45,371

PVF@ 14% 0.877 0.769 0.675 0.592 0.519

Present Value of Inflows 4,95,505 4,00,841 3,29,695 2,74,586 2,31,148

Evaluation :

Aggregate Present Value of Cash Inflows 17,31,775

Add: Present Value of Salvage Value (4,00,000 x 0.519) 2,07,600

Add: Tax saving on Short-term Capital Loss

(4,74,609 - 4,00,000) x 0.35 x 0.519 13,553

Present Value of all Cash Inflows 19,52,928

Cost of the M achine 20,00,000

Net Present Value -47,072

Decision: Since Net Present Value is negat ive Leasing at this rate is not feasible.

QUESTION NO.5CABC Ltd. is contemplat ing having an access to a machine for a period of 5 years. The Company

can have the use of the machine for the st ipulated period through leasing arrangements or the requisite amount

can be borrowed to buy the machine.In case of leasing, the company received a proposal to pay annual end of

year rent of `2.4 lakhs for a period of 5 years.In case of purchase (which costs `10,00,000/ -) the company would

have a 12%, 5 year loan to be paid in equated installments, each installment becoming due at the beginning of

each year. It is est imated that the machine can be sold for `2,00,000/ - at the end of 5th year. The company uses

st raight line method of depreciat ion. Corporate tax rate is 30%. Post tax cost of capital of ABC Ltd. is 10%.You are

required to advice

(i)Whether the machine should be bought or taken on lease.

(ii)Analyse the financial viability from the point of view of the lessor assuming 12% tax cost of capital.

PV of Rs.1 @ 10% for 5 years PV of Rs.1 @ 12% for 5 years

1 .909 .893




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2 .826 .797

3 .751 .712

4 .683 .636

5 .621 .567

Solution:

(i) Loan Alternative

Calculation of loan installment:

`10,00,000 / 1+ (PVAF 12%, 4) = `10,00,000 / (1 + 3.038) = `2,47,647

Bifurcation Table :

Opening Interest Principal Closing

Year Balance @12% Instalments Repayment Balance

` ` ` ` `

0 10,00,000 - 2,47,647 2,47,647 7,52,353

1 7,52,353 90,282 2,47,647 1,57,365 5,94,988

2 5,94,988 71,398 2,47,647 1,76,249 4,18,740

3 4,18,740 50,249 2,47,647 1,97,398 2,21,342

4 (approx) 2,21,342 26,305 2,47,647 2,21,342 0

10,00,000(approx)


Year Interest (1 – tax) Principal Amt. Tax Saving on Dep. Salvage Value

0 - 2,47,647

1 63,197 1,57,365 (48,000) -

2 49,979 1,76,249 (48,000) -

3 35,174 1,97,398 (48,000) -

4 18,414 2,21,342 (48,000)

5 - - (48,000) (2,00,000)

Calculation of Net Cash Flow:

Year NCF PVF@ 10.00% Present Value

0 2,47,647 1 2,47,647

1 1,72,562 .909 1,56,859

2 1,78,228 .826 1,47,216

3 1,84,572 .751 1,38,614

4 1,91,755 .683 1,30,969

5 (2,48,000) .621 (1,54,008)


Leasing Decision: Calculation of Present Value of Outflows

Yrs. 1-5 `2,40,000 x (1 - 0.30) x 3.790 = `6,36,720

Decision: Leasing opt ion is viable.

(ii) From Lessor’s Point of View (`)

Cost of M achine (-) 10,00,000

PV of Post tax lease Rental (` 2,40,000 x 0.7 x 3.605) 6,05,640

PV of Depreciat ion tax shield (`1,60,000 x 0.3 x 3.605) 1,73,040

PV of salvage value (`2,00,000 x 0.567) 1,13,400 8,92,080

NPV (-) 1,07,920

Decision– Leasing proposal is not viable.

QUESTION NO.5DThe Finance manager of ABC Corporat ion is analyzing firms policy regarding computers which

are now being leased on yearly basis on rental amount ing to ̀ 1,00,000 per year. The computers can be bought for




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`5,00,000. The purchase would be financed by 16% and the loan is repayable in 4 equal annual installments.

On account of rapid technological progress in the computer indust ry, it is suggested that a 4-year economic life

should be used instead of a 10-year physical life. It is est imated that the computers would be sold for `2,00,000

at the end of 4 years.

The company uses the st raight line method of depreciat ion. Corporate tax rate is 35%.

(i)Whether the equipment be bought or be taken on lease?

(ii)Analyze the financial viability from the point of view of the lessor, assuming 14% cost of capital.

(iii)Determine the minimum lease rent at which lessor would break even.

Solution:

(i)Evaluation From Point Of View Of Borrower-PV Of Outflow For Borrower

Year Interest Principal Tax Salvage Net

Net Repayment Saving value Cash

Of On Adjusted Outflow

Tax Depreciation For Tax

1 52000 98,699 (26,250) - 1,24,449

2 41735.2 1,14,491 (26,250) - 1,29,976

3 29828.5 1,32,809 (26,250) - 1,36,387

4 16053.7 1,54,001 (26,250) (2,00,000) -56,195

Present Value of Cash Flows under LOAN OPTION

Year NetFlow [email protected]% PV

1 1,24,449 0.906 1,12,751

2 1,29,976 0.820 1,06,580

3 1,36,387 0.743 1,01,336

4 -56,195 0.673 -37,819

2,82,848

Present Value of Cash Flows under Leasing Option :`1,00,000 (1- 0.35) x 3.142 = ` 2,04,230

Decision:Hence leasing should be preferred as cash flow is least in this opt ion.

Working Notes:

1.Equated Annual Instalment =798.2

5,00,000 = ` 1,78,699 (rounded)

2.Depreciation p.a =4

2,00,000-5,00,000

3.Kd = 16 ( 1- .35) = 10.4%

4.Bifurcation Table



` ` ` ` `

1 5,00,000 80,000 Rs. 1,78,699 98,699 4,01,301

2 4,01,301 64,208 Rs. 1,78,699 1,14,491 2,86,810

3 2,86,810 45,890 Rs. 1,78,699 1,32,809 1,54,001

4 1,54,001 24,698 Rs. 1,78,699 1,54,001 -

(ii) Analyzing financial viability from Lessor's point of view

(a)Determination of Cash Flow after Tax

`

Annual Rent 1,00,000

Less: Depreciat ion 75,000

EBT 25,000




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Less: Tax @ 35% 8,750_

Profit after Tax 16,250

Add: Depreciat ion 75,000

91,250

(b)Computation of Net Present Value `

Present Value of Cash inflow (` 91,250 x 2.914) 2,65,903

Add: PV of Salvage Value (` 2,00,000 x 0.592) 1,18,400

Purchase Price 3,84,303

NPV (5,00,000)

(1,15,697)

Decision:Thus proposal is not financially viable from lessor's point of view.

(iii)Break Even Lease Rent

X x (1-.35) x 2.914 + ` 75,000 x 35% x 2.914 + ` 2,00,000 x .592 = ` 5,00,000

or 1.8941 X +76,492.5 + 1,18,400 = `5,00,000 or X = `1,61,083

Lease vs Purchase Option

QUESTION NO. 6Evergreen Pvt . Ltd. is considering the possibilit y of purchasing a mult ipurpose machine(asset )

which cost ` 10.00 lakhs. The machine(asset ) has an expected life of 5 years. The machine(asset ) generates Rs.

6.00 lakhs per year before Depreciat ion and Tax, and the M anagement wants to dispose the machine(asset ) at

the end of 5 years which will fetch Net ` 1.00 lakh. The Depreciat ion allowable for the machine(asset ) is 25% on

writ ten down value and the Company’s Tax rate is 50%. The company approached a NBFC for a five year Lease for

financing the asset which quoted a rate of ` 28 per thousand per month.Lease Rental is payable annually. The

Company wants you to evaluate the proposal with purchase opt ion taking the Cost of Capital is 12 % and for

lease opt ion it want you to consider a discount rate of 16%.

0 1 2 3 4 5

PV @ 12% 1.000 0.893 0.797 0.712 0.636 0.567

PV@ 16% 1.000 0.862 0.743 0.641 0.552 0.476

WHEN LOAN IS TAKEN FOR PAYING LEASE RENT

QUESTION NO.7R Ltd., requires a machine for 5 years. There are two alternat ives either to take it on lease or buy.

The company is reluctant to invest init ial amount for the project and approaches their bankers. Bankers are ready

to finance 100% of its init ial required amount at 15% rate of interest for any of the alternat ives.

Under lease opt ion, upfront Security deposit of ̀ 5,00,000/ -[to be arranged by lessee through borrowing] is payable

to lessor which is equal to cost of machine. Out of which, 40% shall be adjusted equally against annual lease

rent . At the end of life of the machine, expected scrap value will be at book value [ it means profit loss on sale on

machine will be zero] after providing, depreciat ion @ 20% on writ ten down value basis.

Under buying opt ion, loan repayment is in equal annual installments of principal amount, which is equal to

annual lease rent charges [It means annual lease rent is `1,00,000]. However in case of bank finance for lease

opt ion, repayment of principal amount equal to lease rent adjusted every year, and the balance at the end of 5th

year.

Assume Income tax rate is 30%, interest is payable at the end of every year and discount rate is @ 15% p. a .The

following discount ing factors are given:

Year 1 2 3 4 5

Factor 0.8696 0.7562 0.6576 0.5718 0.4972

Which opt ion would you suggest on the basis of net present values?




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Equated Annual Loan-Amount Paid At The Beginning Of The Year

QUESTION NO.8ABC Company has decided to acquire a ̀ 5,00,000 pulp cont rol device that has a useful life of ten

years. A subsidy of ̀ 50,000 is available at the t ime device is acquire and placed into service. The device would be

depreciated on st raight-line basis and no salvage value is expected. The company is in the 50% tax bracket . If the

acquisit ion is financed with a lease, lease payments of ` 55,000 would be required at the beginning of each year.

The company can also borrow at 10% repayable in equal instalments inclusive of interest . Debt payments would

be due at the beginning of each year :

(i)What is the present value of cash out flow for each of these financing alternat ives, using the after-tax cost of

debt?

(ii)Which of the two alternat ives is preferable ?

Calculation Of Diminishing Lease Rental

QUESTION NO.9AFair finance a leasing company has been approached by a prospect ive customer intending to

acquire a asset cost ing ` 3crores.The customer in order to leverage his tax posit ion has requested a quote for a

three year lease with rentals payable at the end of each year but in a diminishing (reducing)manner such that

they are in the rat io of 3:2:1.Depreciaton can be assumed to be on st raight line basis and Fair finance’s marginal

tax rate is 35%.The target rate of return for Fair Finance on the t ransact ion is 10%.Calculate lease rental to be

quoted for lease of three years.

QUESTION NO.9BClassic Finance,a Leasing Company, has been approached by A prospect ive customer intending

to acquire a machine whose cash down price is ̀ 6 crores. The customer, in order to leverage his tax posit ion, 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 rat io of 3: 2: 1. Depreciat ion can be assumed to be on WDV basis at 25% and classic

finance’s marginal tax rate is 35%.The target rate of return for classic finance on the t ransact ion is 10%.You are

required to calculate the lease rents to be quoted for the lease for three years.Ignore Salvage Value & Profit &

Loss On Salvage Value.

Solution:


1.The given quest ion is asked from the point of view of Lessor

2.Recall Concept "Calculat ion Of Annual Lease Rent For Lessor When Discount Rate is given"

Equation:

PV of Cash Out flow For Lessor = PV of Cash Inflow For Lessor

or Cost Of Asset = PV of Lease Rent Received Net Of Tax + PV Of Tax Saving On Depreciat ion

or 600 = 3.335X + 102.43

or X = `149.20 Lakhs

Year wise lease rental will be ` lakhs

Year 1 3 X 149.196 447.59

Year 2 2 X 149.196 298.39

Year 3 1 X 149.196 149.20

Working Notes

Calculation of PV Of Tax Saving On Depreciation (` Lakhs)

Year Cost / WDV Dep. @ 25 % Tax shield @ 0.35 PVF PV of Dep. Tax Saving

1 600.00 150.00 52.50 0.909 47.72

2 450.00 112.50 39.38 0.826 32.53

3 337.50 84.38 29.53 0.751 22.18_

102.43




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Calculation of PV Of Annual Lease Rent Net Of Tax Received

Let the normal annual lease rent were to be “ X” then

Year Post tax PVF PV of cash flow

1 3 x (1-0.35 ) or 1.95 x 0.909 1.773 x

2 2 x (1-0.35 ) or 1.30 x 0.826 1.074x

3 1 x ( 1-0.35 ) or 0.65x 0.751 0.488x_

3.335 x

Calculation Of Cost Of Asset

QUESTION NO.10M / s Gama & Co. is planning of installing a power saving machine and are considering buying

or leasing alternat ive. The machine is subject to st raight line method of depreciat ion. Gama &Co. can raise debt

at 14% payable in five equated annual instalments of ` 1,78,858 each, at the beginning of the year. In case of

leasing, the company would be required to pay an annual end of year rent of 25% of the cost of machine for 5

years.The Company is in 40% tax bracket . The salvage value is est imated at ` 24,998 at the end of 5 years.

Evaluate the two alternat ives and advise the company by considering after tax cost of debt concept under both

alternat ives.P.V. Factors 0.9225, 0.8510, 0.7851, 0.7242, 0.6681 respect ively for 1 to 5 years.

Solution:

(1)Calculation of Cost of M achine : 178858=years)4(14%,PVAF+1

M achineofCost

Cost of M achine = 178858 3.9137 = `699998

(2)Bifurcation of Interest and Principal Components :

Year Opening Instalment Principal Interest Closing Balance

0 699998 178858 178858 0 521140

1 521140 178858 105898 72960 415242

2 415242 178858 120724 58134 294518

3 294518 178858 137625 41233 156893

4 156893 178858 156893 21965 Nil

5 – – – – –

(3)Calculation of Depreciation : Depreciat ion =5

24998–699998= ` 1,35,000 p.a.

(4)Calcualtion of Discount Rate : Kd = Interest (1 – tax) = 14 (1 – .40) = 8.4%

(5)Calculation of Lease Rent p.a.:Lease Rent p.a. = 699998 25% = `1,75,000 (approx.)

Present Value of Outflow Under Lease Option

Year Lease Rent (1 – tax) [email protected]% Present Value

1 - 5 1,75,000 (1 – .40)=105000 3.9509 414844.50


Year Interest (1 – tax) Principla Amt Tax Saving on Dep. Salvage Value

0 – 1.78858 – –

1 43776 105898 (54,000) –

2 34,880 1.20724 (54,000) –

3 24740 137625 (54,000) –

4 13179 156893 (54,000) –

5 – – (54,000) (24,998)

Calculation of Net Cash Flow:




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Year CF PVF@ 8.4% Present Value

0 178858 1 178858

1 95674 .9225 88259

2 101604 .851 86465

3 108365 .785 85077

4 116072 .7242 84059

5 (54,000) .6681 – 36077

5(Salvage Value) (24998) .6681 – 16701

Present Value of Out flow under Loan 469940

Decision: The company is advised to opt for leasing as the total present value of cash out flow is lower by `

55095.50.

Quotations From Two Lessor

Question No.11P Ltd had planned to acquire a machine(asset ) cost ing `50 Lakhs through leasing. Quotat ions

from 2 leasing companies have been obtained which are summarized:

Quote A Quote B

Lease term 3 years 4 years

Init ial lease rent (year 0) `5.00 Lakhs `1.00 Lakh

Annual lease rent payable at the end `21.06 Lakhs `19.66 Lakhs

P Ltd evaluates investment proposals at 10% cost of capital and its effect ive tax rate is 30%. Terminal payment in

both the cases is negligible and may be ignored.M ake calculations and evaluate which quote is beneficial to P

Ltd. Present value factors at 10% rate for years 1-4 are respect ively 0.91, 0.83, 0.75 and 0.68. Considerat ions may

be rounded off to 2 decimals in Lakhs.

DEPRECIATION

QUESTION NO.12AThe original cost of the asset is ` 2,50,000.The useful life of the asset is 10 years and net

residual value is est imated to be ` 50,000. Calculate the amount of depreciat ion to be charged every year under

SLM ?

Solution:

Depreciat ion p.a = AssetOf Life

Value Salvage Assetsof Cost -

=Years 10

000,05000,50,2 -

=`20,000

QUESTION NO.12BThe cost of machine is `20,00,000 having a useful life of 5 years with the salvage value of `

4,00,000. The Company follows the writ ten down value method of depreciat ion at the rate of 25 per cent .Calculate

Depreciat ion of each year.

Solution:

Schedule of Depreciation

Year Opening WDV Depreciation Closing WDV

1 20,00,000 5,00,000 15,00,000

2 15,00,000 3,75,000 11,25,000

3 11,25,000 2,81,250 8,43,750

4 8,43,750 2,10,938 6,32,812

5 6,32,812 1,58,203 4,74,609




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QUESTION NO.12CCost Of Assets=`160 ;Life : 5Years;Salvage Value = `10.Calculate Depreciat ion as per Sum of

Years Digit M ethod?

Solution :

Amount to be depreciated = 160 - 10 = 150 ; Life = 5 Years ; Sum = 1+2+3+4+5 = 15

Year Depreciation

1 150 x 5/15 = 50

2 150 x 4/15 = 40

3 150 x 3/15 = 30

4 150 x 2/15 = 20

5 150 x 1/15 = 10

Break Even Lease Rental (BELR) from Lessor’s point of View

From the lessor ’s view point , BELR is the minimum (floor) lease rental, which he should accept . In t his case also

NAL should be zero. Any lease rent below BELR should not be accepted. It is to be noted that while comput ing

NAL, the over all cost of capital of the firm should be used. The computat ion of BELR from lessor ’s point of view

can be understood with the help of following illust rat ion.

QUESTION NO.13With the following data available compute the BELR that ABC Ltd. should charge from lessee.

Cost of Asset ` 150 Lakh

Expected Useful Life 5 year

Salvage Value of M achine at the end of 5 years ` 10 lakh

Rate of Depreciat ion (WDV) 25%

Ko 14%;

Tax Rate 35%

Asset will const itute a separate block for depreciat ion propose.

Solution:

PV Of Cash Out flow = PV Of Cash Inflows [ Also student can recall concept no. 16]

`1,50,00,000 = Annual Lease Rental x (1-.35) x PVAF(14%,5 years)+ PV of Tax Saving of Depreciat ion + PV of

Salvage Vale Adusted for tax

`1,50,00,000 = Annual Lease Rental x .65 x 3.433 + 27,34,184 + 11,99,478

Annual Lease Rental = `49,59,259

Working Notes:

Calculation of PV of Tax Saving on Depreciation :

Year Dep@25% Tax Saving@35% PVF @14% PV

1 3750000 1312500 .877 1151062.5

2 2812500 984375 .769 756984.375

3 2109375 738281 .675 498339.675

4 1582031 553711 .592 327796.912

5 - - -

PV of Tax Saving on Depreciat ion 2734184.00

Calculation of PV of Salvage Vale Adusted for tax :

Original cost 15000000

(-) Depreciat ion t ill date 10250906

WDV Remaining 4746094

Salvage Value 1000000

Loss on Sale of Asset 3746094

Tax soved on loss @35% 1311133




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Salvage Value Adjusted for tax 1000000 + 1311133 = 2311133

PV of Salvage Vale Adusted for tax = 2311133 x PVF (14%, 5 years ) = 1199478

Sales back Lease

Question NO.14X Ltd. had only one water pollut ion control machine(asset) which was subject to rate of depreciat ion

of 100% in the very first year of installat ion.Due to fund crunch, X Ltd. decided to sell the machine(asset ) which

can be sold in the market to anyone for `5,00,000.Understanding this from a reliable source. Y Ltd came forward

to buy the machine(asset ) for `5,00,000 and lease it to X ltd for lease rental of `90,000 p.a. for 5 year X Ltd.

decided to invest the net sale proceed in a risk free deposit , fetching yearly interest of 8.75% to generate some

cash flow. It also decided to relook the ent ire issue afresh after the said period of 5 years.

Another company, Z Ltd. also approached X Ltd proposing to sell a similar machine(asset ) for `4,00,000 to the

lat ter and undertook to buy it back at the end of 5 year for ̀ 1,00,000 provided the maintenance were ent rusted to

X Ltd. for yearly charge of ̀ 15,000. X Ltd. would ut ilize the net sale proceeds of the old machine(asset ) to fund this

machine(asset ).The marginal rate of tax of X Ltd. is 34% and its weighted average cost of capital is 12%. Which

Alternat ive would you recommend ?

Discount ing Factors @ 12% are:

0.893 0.797 0.712 0.636 0.567

Evaluation When Housing Loan Is Swapped

QUESTION NO.15You have a housing loan with one of India’s t op housing finance companies. The amount

outstanding is ` 1,89,540. There are five more instalments to go, each being ` 50,000. Another housing finance

company has offered to take over this loan on a seven year repayment basis. You will be required to pay ` 36,408

p.a with the first instalment falling a year later. The processing fee is 3% of amount taken over. For swapping you

will have to pay ` 12,000 to the first company. Should you swap the loan ?

[Hint : At 10% PVAF will be 4.8684;At 11% PVAF will be 4.7122]

Housing Loan Adjustment When Interest Rates Are Revised

QUESTION NO.16M r. A has secured from a housing bank, a six year housing loan of ` 12,00,000. The loan was

st ructured as follows :

Loan Amount — ` 12,00,000

Repayment — Six equated annual instalments

Reference Base — Prime Lending Rate

Reference Rate — 9% on the date of loan

Interest on Loan — 1 percentage point over reference rate of 9%

Annual Installment — ` 2,75,530

Two years after the loan was granted, the prime rate moves down to 8% and the effect ive rate on the loan

automat ically stood revised to 9%.

Required :

(1)Determinat ion of Unpaid principal just before rate changes.

(2)Re-Computat ion of Equated Annual M ethod for revised period at revised rate

EM I-Instalment Paid At The End

QUESTION NO.17Fixed Interest rates quoted on housing loans by a nat ionalized bank for three different maturity

periods are as follows. Compute EM I for a loan of ` 72,500 for each of the maturit ies.




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Option I Option II Option III

Interest rate 10% (3 years) 11% (5 years) 12% (10 years)

[Hint : PVAF (.833%,36 months) = 30.99 ; PVAF (.9167%,60 months) = 45.99 ; PVAF (1%,120 months) = 69.70 ]

Solution:

Option I Option II Option III

Annual Interest 10% 11% 12%

Loan Period 3 years 5 years 10 years

Interest Rate adjusted on one

month basis 0.833 0.916 1.000

Loan Amount ` 72,500 ` 72,500 ` 72,500

PVAF

for 36/60/120 months 30.99 45.99 69.70

EM I =

Loan Amount / PVAF ` 2339.46 ` 1576.43 ` 1040.17

Calculation Of Lease Rental By Using Desired Return Of Lessor On The basis Of Gross Value Of Asset

QUESTION NO.18W Limited is faced with a decision to purchase or acquire on lease a mini car. The cost of the

mini car is ` 1,26,965. It has a life of 5 years. The mini car can be obtained on lease by paying equal lease rentals

annually. The leasing company desires a return of 10% on the gross value of the asset . W Limited can also obtain

100% finance from its regular banking channel.The rate of interest will be 15% p.a. and the loan will be paid in

five annual equal instalments, inclusive of interest .The effect ive tax rate of the company is 40%. For the purpose

of taxat ion it is to be assumed that t he asset will be writ ten off over a period of 5 years on a st raight line

basis.Advise W Limited about the method of acquiring the car.

Assume all cash flows are arising at the beginning of each year.For your exercise use the following discount

factors:

Years

Discount rate 1 2 3 4 5

10% 0.91 0.83 0.75 0.68 0.62

15% 0.87 0.76 0.66 0.57 0.49

9% 0.92 0.84 0.77 0.71 0.65

Solution:

Tutorial Notes: The quest ion is based on "LESSEE AND LOAN OPTION" and not "LESSOR".

Loan Option:

Computat ion of annual loan repayment instalment

Years) 1n%, PVAF(r+1

LoanAmount

=Years) 1%,5 PVAF(15+1

1,26,965

=2683.85497836

1,26,965= `32935 p.a

Bifurcation Table :

Year Opening Bal Int @15% Instalment Principal Closing Balance

0 126965 - 32935 32935 94030

1 94030 14105 32935 18830 75200

2 75200 11280 32935 21655 53545

3 53545 8032 32935 24903 28642

4 28642 4293* 32935 28642 Nil

Schedule of PV Of Cash Outflows Under Loan Option




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Year Int (1-Tax) Principal Tax Saving NCF PVF@9% PV

On Depreciation

0 - 32,935 - 32935 1.00 32,935

1 8463 18,830 (10,157) 17136 0.92 15,765

2 6768 21,655 (10,157) 18266 0.84 15,343

3 4819 24,903 (10,157) 19565 0.77 15,065

4 2576 28,642 (10,157) 21061 0.71 14,953

5 - - (10,157) (10157) 0.65 (6,602)

Total ` 87,459

Computation of Annual lease rentals: Years) 1%,5 PVAF(10+1

AssetOf Cost

=

3.170+1

1,26,965= ` 30,447

Schedule of Cash outflows – Leasing alternative (`)

Year Lease payment Tax shield After tax cash out flows PVF@9% PV

0 30,447 - 30,447 1.00 30,447

1-4 30,447 (12,179) 18,268 3.24 59,188

5 - (12,179) (12,179) 0.65 (7,916)

Total Present Value 81,719

Decision: The present value of cash out flows under lease financing is ` 81,719 while that of debt financing (i.e.

owning the asset ) is ` 87,335. Thus leasing has an advantage over ownership in this case.

Consumer Finance

QUESTION NO.19 Lenders and Company has come up with a special offer for its customers, for purchase of TVs,

Refrigerators. Elect ronic equipment and other home appliance. Sales persons reveal the following :

* The offer is available for a minimum purchase of items for list price of ` 18,000

* The purchase price can be paid in 12 equal monthly instalments. The first payment is to be made on the date of

purchase and the remaining 11 instalments are payable each of the following months, on the same calendar date

of purchase.

* If the buyers opt to pay in cash, they can get a steep discount of ̀ 1173 for each lot of purchases worth ̀ 18,000/

(a)Is there an interest element involved in Zero interest offer ?

(b)If yes, what is the rate ?

(c)Which offer would you prefer ?

[Given: At 1% PVAF is 10.3676;At 2 % PVAF is 9.7868 ]

EPQ(EXTRA PRATICAL QUESTIONS)

QUESTION NO. 1(Exam Question)(20 M arks ) ABC Ltd. sells computer services to its clients. The company has

recent ly completed a feasibilit y study and decided to acquire an addit ional computer, the details of which are as

follows

(1) The purchase price of the computer is Rs.2,30,000; maintenance, property taxes and insurance w ill be

Rs.20,000 per year. The addit ional expenses to operate the computer are est imated at Rs.80,000. If the computer

is rented from the owner, the annual rent will be Rs.85,000, plus 5% of annual billings. The rent is due on the last

day of each year.

(2) Due to compet it ive condit ions, the company feels that it w ill be necessary to replace the computer at the end

of three years with a more advanced model. Its resale value is est imated at Rs.1,10,000.

(3) The corporate income tax rate is 50% and the st raight line method of depreciat ion is followed.

(4) The est imated annual revenue billing for the services of the new computer will be Rs.2,20,000 during the first




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year, and Rs.2,60,000 during the subsequent two years.

(5) If the computer is purchased, the company will borrow to finance the purchase from a bank with interest at

16% per annum. The interest will be paid regularly, and the principal will be returned in one lump sum at the end

of the year 3.Should the company purchase the computer or lease it?

Assume (i) Cost of Capital as 12%, (ii) St raight Line M ethod of Depreciat ion, (iii) Salvage Value of Rs.1,10,000 and

evaluate the proposal from the point of view of lessor also.Additional Analysis:

1.M aintenance, Property taxes and Insurance are assumed to be incurred by Owner of the asset unless otherwise

specifically stated.

2.Operating Costs are assumed to be incurred bu User of the asset unless otherwise specifically stated.

Q.1

Working Note: Calculat ion Of Discount Rate : Kd (1-Tax) = .16(1-.50) = 8 %

Computation of Present Value of Borrowing Option :-

(1) (2) (3) (4) (5) (6)

Year Principal Interest M aintenance Depreciation Salvage

Payment Payment etc Value

1. - 36,800 20,000 40,000 -

2. - 36,800 20,000 40,000 -

3. 2,30,000 36,800 20,000 40,000 (1,10,000)

(7) = 50% of [3+4+5] (8) = [2+3+4-6-7] (9) (10)

Tax Saved Net Cash Outflow PVF@8% Present Value

(48,400) 8400 .926 77789

(48,400) 8400 .857 7199

(48,400) 128400 .794 101950

Present Value of Out flow Under Purchase Opt ion 116928

Computation of Present Value of Leasing Options :-

(1) (2) (3) (4) (5) (6) (7)

50% of (2+3) 5=2+3-4

Year Lease 5% of Tax Cash PVF@ Present

Rent Billing Paid Saved Outflow 8% Value

1 85000 11000 48000 48000 .926 44448

2 85000 13000 49000 49000 .857 41993

3 85000 13000 49000 49000 .794 38906

Present Value of Out flow under Leasing Opt ion 125347

Conclusion : Purchase Opt ion is cheaper and hence it should be preferred over Leasing opt ion.

Evaluation from Lessor point of view :-

Year Cash Flow PVF @ 12% Present Value

0 (2,30,000) 1 (2,30,000)

1 58,000 .893 51,794

2 59,000 .797 47,023

3 1,69,000 .712 1,20,328

(10,855)

Conclusion : Leasing is not viable from Lessor's point of view , Since Net Present Value of Cash Inflow negat ive.

Working Notes

(1)Calculation of Cash Flow :

Year 1 Year 2 Year 3

Lease Rental Income Received 85,000 85,000 85,000




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Add : 5 % Bill Amount Received 11,000 13,000 13,000

Less : Property Tax etc (20,000) (20,000) (20,000)

Less : Depreciat ion - (40,000) (40,000) (40,000)

Profit Before Tax 36,000 38,000 38,000

Less : Tax @ 50% 18,000 19000 19000

Profit After Tax 18,000 19000 19000

+ Depreciat ion 40,000 40,000 40,000

Cash Inflow 58,000 59,000 59,000

(2) 3rd year Cash Inflow also include Inflow on account of Terminal Value.[Rs. 59,000+1,10,000=1,69,000]

(3) Depreciat ion p.a. under St raight Line M ethod :

Life

Value SalvageCost Original -

= 3

000,10,1000,30,2 -

= 40,000 p.a

(4) Profit n Loss on Sale of M achine will be Nil as full amount net of Salvage Value have been claimed as depre-

ciat ion.

Book Value 2,30,000

Less : Depreciat ion t ill date 1,20,000

Amount to be writ ten off 1,10,000

Less : Salvage Value 1,10,000

Profit n Loss on Sale Nil_____

Additional Analysis :

(i) Expenses to operate computer which in the present case is Rs. 80,000 are common to both Leasing as well as

Borrowing opt ion and hence it is ignored.

(ii) Revenue on account of est imated annual billing for the services of the new computer will common under both

leasing as well purchasing opt ion and hence accordingly it has been ignored.

(iii) M aintenance , Property Tax and Insurance of Rs. 20,000 are supposed to be paid by owner of the asset .Hence

in our case borrower and lessor will incur this expenses

QUESTION NO. 2 (Exam Question)(20 M arks)(Study M aterial) ABC Ltd. is considering a proposal to acquire a

machine cost ing Rs. 1,10,000 payable Rs. 10,000 down and balance payable in 10 annual equal instalments at

the end of each year inclusive of interest chargeable at 15%. Another opt ion 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 informat ion is

also available.

(i) Terminal Scrap value of Rs. 20,000 is realizable, if the asset is purchased.

(ii) The company provides 10% depreciat ion on St raight Line M ethod on the original cost .

[ Addit ional Analysis : It means full 1,10,000 is to be depreciated ]

(iii) Income tax rate is 50%.

(iv) Cash Flow should be discounted at 15 % .

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

Q.2

Option 1 : Borrowing Option

Working Notes-

In this opt ions the firm has to pay Rs. 10,000 as down payment the balance of Rs. 1,00,000 together with interest

@ 15% is payable in equal instalments. The instalments amount may be calculated by dividing Rs. 1,00,000 by

the PVAF for 10 years at 15% i.e. Equated Annual Instalment = 5.50188

0Rs.1,00,00 = Rs. 19,9255

Working Notes-Bifurcation Table




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Rs. Rs. Rs. Rs. Rs.

1 1,00,000 15,000 19,925 4,925 95,075

2 95,075 14,261 19,925 5,664 89,411

3 89,411 13,412 19,925 6,513 82,898

4 82,898 12,435 19,925 7,490 75,408

5 75,408 11,311 19,925 8,614 66,794

6 66,794 10,019 19,925 9,906 56,888

7 56,888 8,533 19,925 11,392 45,496

8 45,496 6,824 19,925 13,101 32,395

9 32,395 4,859 19,925 15,066 17,329

10 17,329 2,596 19,925 17,329 -

Evaluation From Point Of View Of Borrower-PV Of Outflow For Borrower

Year Interest Principal Tax Salvage Down Net

Net Repayment Saving value Payment Cash

Of On Adjusted Outflow

Tax Depreciation For

Tax

0 - - - - 10,000 10,000

1 7500 4,925 (5,500) - - 6925

2 7131 5,664 (5,500) - - 7295

3 6706 6,513 (5,500) - - 7719

4 6218 7,490 (5,500) - - 8208

5 5656 8,614 (5,500) - - 8770

6 5010 9,906 (5,500) - - 9416

7 4267 11,392 (5,500) - - 10159

8 3412 13,101 (5,500) - - 11013

9 2430 15,066 (5,500) - - 11996

10 1298 17,329 (5,500) (10,000) - 3127

Year Net CF PVF PV

@15%

0 10,000 1.000 10,000

1 6,925 .870 6,025

2 7,295 .756 5,515

3 7,719 .658 5,079

4 8,208 .572 4,695

5 8,770 .497 4,359

6 9,416 .432 4,068

7 10,159 .376 3,820

8 11,013 .327 3,601

9 11,996 .284 3,407

10 3,127 .247 7,72

Present Value of total out flows -51,336

Option II - Evaluation of Lease Option :

Year Lease Rent PVF PV

Net Of Tax @ 15%




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1-10 15,000(1-.50)

=7,500 5.019 37643

Present Value of Out flow = 37643

Advice :If the firm opts to buy the asset , the present value of out flow comes to Rs. 51,336 ; and in case of lease

opt ion, the present value of out flows comes to Rs. 37,641. Hence, the firm should opt fo the lease opt ion. In that

way, the firm will be able to reduce its costs by Rs. 13,695 i.e. Rs. 51,336 - Rs. 37,641 in present value terms. This

may also be reffered to as Net Benefit of Leasing.

Note : Students should have discounted cash flows under both alternat ives at after tax cost i.e.15% (1 - 05) =

7.5%. But since quest ion has asked to discount the cashflow at 15%, thats why we have discounted the cashflow

at 15%.

QUESTION NO. 3 (Exam Question)(14 M arks)S Ltd. discounts its cash flows at 16% and is in the tax bracket of

35%.For the acquisit ion of a machinery worth Rs.10,00,000, it has two opt ions- either to acquire it by taking a

bank loan @ 15%p.a. repayable in 5 yearly instalments of Rs.2,00,000 each plus interest or to lease the asset at

yearly rentals of Rs.3,34,000 for 5 years. In both the cases the instalment is payable at the end of the year.

Depreciat ion is to be applied @15% using “ Writ ten Down Value” (WDV) method. You are required to advise which

of the financing opt ions is to be exercised and why.Ignore Salvage Value

Year 1 2 3 4 5

PVF @ 16% 0.862 0.743 0.641 0.552 0.476

Q.3

Given,Discount Rate = 16% ; Tax Rate = 35%; Cost of the Asset = 10,00,000;Interest=15%p.a. ; Year=5year;Yearly

Installment = 2,00,000;Lease ; Depreciat ion=15%p.a WDV M ethod;Yearly Lease Rental = 3,34,000

Working Notes 1: Calculation of Depreciation

Year Opening Balance Depreciation@15% Closing Balance

1 1000000 150000 850000

2 850000 127000 722500

3 722500 108375 614125

4 614125 92118.75 522006.25

5 522006.25 78301 443705.25

Working Note 2 : Calculation Of Interest

Year Opening Balance Interest@15% Closing Balance

1 10,00,000 1,50,000 8,00,000

2 8,00,000 1,20,000 6,00,000

3 6,00,000 90,000 4,00,000

4 4,00,000 60,000 2,00,000

5 2,00,000 30,000 Nil

Calculation of Present Value of Outflow

Under Lease:

Year LeaseRental Net Of Tax PVAF@16% PresentValue

1-5 3,34,000(1-.35)= 217100 3.274 710785.4

Present Value of Cash Out flow 710785.4

Under Loan:

Year Principal Interest Tax Saving Total Net

Repayment Net of Tax on Depreciation Cash Outflow

1 2,00,000 97,500 (52,500) 2,45,000

2 2,00,000 78,000 (44,625) 2,33,375

3 2,00,000 58,500 (37,931) 2,20,569

4 2,00,000 39,000 (32,242) 2,06,758




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5 2,00,000 19,500 (27,405) 1,92,095

Year Cash Flow PVF@16% Present Value

1 2,45,000 .862 2,11,190

2 2,33,375 .743 1,73,398

3 2,20,569 .641 1,41,384

4 2,06,758 .552 1,14,130

5 1,92,095 .476 91,437

Present Value 0f Cash Out flow 7,31,539

Decision: Sundaram Ltd Company should choose Lease Opt ion.

QUESTION NO. 4(Exam Question)(8 M arks)XYZ Ltd. requires an equipment cost ing Rs.10,00,000; the same will

be ut ilised over a period of 5 years. It has two financing opt ions in this regard :

(i) Arrangement of a loan of Rs.10,00,000 at an interest rate of 13 per cent per annum; the loan being repayable

in 5 equated year end instalments;the equipment can be sold at the end of fifth year for NET Rs.1,00,000.

(ii) Leasing the equipment for a period of five years at an Yearly rental of Rs.3,30,000 payable at the year end.

The rate of depreciat ion is 15 per cent on Writ ten Down Value (WDV) basis, income tax rate is 35 per cent and

discount rate is 12 per cent .Advise the XYZ Ltd. that which of the financing opt ions is to be exercised and why.

Q.4

Working Notes:

1.Calculation Of Depreciation As Per WDV

Year Opening Balance Depreciation Closing Balance Tax Saving On Dep@35%

1 10,00,000 1,50,000 8,50,000 52500

2 8,50,000 1,27,500 7,22,500 44625

3 7,22,500 1,08,375 6,14,125 37931

4 6,14,125 92,119 5,22,006 32242

5 5,22,006 78,301 4,43,705 27405

Equated Annual Instalment = 0Rs.2,84,32=3.5172

00Rs.10,00,0

Working Notes-Bifurcation Table



Rs. Rs. Rs. Rs. Rs.

1 10,00,000 1,30,000 2,84,320 1,54,320 8,45,680

2 8,45,680 1,09,938 2,84,320 1,74,382 6,71,298

3 6,71,298 87,269 2,84,320 1,97,051 4,74,247

4 4,74,247 61,652 2,84,320 2,22,668 2,51,579

5 2,51,579 32,741 2,84,320 2,51,579 Nil


Year Interest (1 –tax) Principal Tax Saving on Dep. Salvage Value

1 84500 1,54,320 (52500) -

2 71460 1,74,382 (44625) -

3 56725 1,97,051 (37931) -

4 40074 2,22,668 (32242) -

5 21282 2,51,579 (27405) (1,00,000)


Year NCF PVF@ 12.00% Present Value

1 1,86,320 .893 1,66,384




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2 2,01,217 .797 1,60,370

3 2,15,845 .712 1,53,682

4 2,30,500 .636 1,46,598

5 1,45,456 .567 82473

Present Value of Total Outflows 709507

Option B : Leasing the equipment

Lease Rent 330,000

Tax Saving (115,500)

Outflow 214,500

Present Value of Out flow = 214,500 x 3.605 = 773272.5

Decision:Since Present Value of Out flows is lower in the Borrowing opt ion, XYZ Ltd. should avail of the loan and

purchase the equipment .

QUESTION NO.5(Exam Question)(7 M arks ) ABC Leasing Ltd. has been approached by a client to write a five

years on an lease asset cost ing Rs.10,00,000 and having est imated salvage value of Rs. 1,00,000 thereafter. The

company has a after tax required rate of return of 10% and its tax rate is 50%. It provides depriciat ion @ 331/3%

on writ ten down value of the asset . What lease will provide the company its after tax required rate of return?

Q.5


1.The given quest ion is asked from the point of view of Lessor

2.Recall Concept "Calculat ion Of Annual Lease Rent For Lessor When Discount Rate is given"

Equation:

PV of Cash Out flow For Lessor = PV of Cash Inflow For Lessor

or Cost Of Asset = PV of Lease Rent Received Net Of Tax + PV Of Tax Saving On Depreciat ion & Salvage Value

or 10,00,000 = Annual Lease Rental ( 1- .50 ) × 3.791 + 425018

or Annual Lease Rent = Rs. 303340

Working Notes :

Calculation Of Present Value Of Tax Saving on Depreciation & Salvage Value :

Year Depreciation Tax Saving / Cash flow PVF Present Value

(Rs.) (Rs.) @ 10% (Rs.)

1. 3,33,333 1,66,667 .909 1,51,500

2. 2,22,222 1,11,111 .826 91,778

3. 1,48,148 74,074 .751 55,630

4. 98,766 49,383 .683 33,728

5. 65,844 32,922 .621 20,444

5. Salvage Value 1,00 ,000 .621 62,100

5. Tax Saving On Loss15843 .621 9,838

Present Value of Inflows 4,25,018

Working Note:

Profit & Loss On Sale Of Asset


(-)Depreciat ion Till Date 8,68,313

WDV Remaining 1,31,687

(-)Sale Value 1,00,000

Loss on sale of assset 31,687

Tax Saved @ 35% 15,843




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QUESTION NO.6(Exam Question)Alfa Ltd. desires to acquire a diesel generat ing set cost ing Rs. 20 lakh which

will be used for a period of 5 years. It is considering two alternat ives

(i) taking the generat ing set on lease or

(ii) purchasing the asset out right by raising a loan. The company has been offered a lease cont ract wit h a lease

payment of Rs. 5.2 lakh per annum for five years payable in advance. Company’s banker requires the loan to be

repaid @ 12% p.a. in 5 equated annual instalments, each installment being due at the beginning of the each year.

Tax relevant depreciat ion of the generator is 20% as per WDV method. At the end of 5th year the generator can

be sold at Rs. 2,00,000. M arginal Tax rate of Alfa Ltd. is 30% and its post tax cost of capital is 10%.Determine:

(i)The Net Advantage of Leasing to Alfa Ltd. and recommend whether leasing is financially viable.

(ii)Break Even Lease Rental.

Q.6

(1)Calculation of annual installment : Years)PVAF(12%,4+1

20=

038.3+1

20= 4.95 lakhs

(2)Bifurcation Table :

Year Opening Bal Int Instalment Principal Closing Bal

0 20 Nil 4.95 4.95 15.05

1 15.05 1.806 4.95 3.144 11.906

2 11.906 1.429 4.95 3.071 8.025

3 8.025 .963 4.95 3.537 4.488

4 4.488 .539 4.95 4.411 Nil (approx)

(3)PV of Tax Saving On Interest

Year Interest Tax saving PVF @ 8.4% PV

1 1.806 1.2642 .923 1.1668566

2 1.429 1.0003 .851 .8512553

3 .963 .6741 .785 .5291685

4 .539 .3773 .724 .2731652

2.82000_or 3

(4)Depreciation Schedule

Year Depreciation @ 20 % Tax Saving [email protected]% PV

1 4 1.2 .923 1.1076

2 3.2 .96 .851 .81696

3 2.56 .768 .785 .60288

4 2.048 .6144 .724 .4448256

5 1.6384 .49152 .668 .32833536

13.4464 3.30000____

(5)Tax Saving On Sale Of M achine

Book Value 20.0000

(-) Depreciat ion Till Date 13.4464

WDV 6.5536

Sale Value 2.0000

Loss On Sale 4.5536

Tax Saving On Loss 1.36608

PV Of Salvage value Adjusted For Tax (2.0000 + 1.36608) x PVF (8.4%,5 Years) = 2.25 (approx)

(6)PV Of Principal Repayment

Year Principal Paid [email protected]% PV

0 4.95 1 4.95




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1 3.144 .923 2.901912

2 3.071 .851 2.613421

3 3.537 .785 2.776545

4 4.411 .724 3.193564

16.435442 or 17 (approx)

PV of Loan Option

PV Of Principal Payment 17

PV of Interest Net Of Tax 3

Note:Remember direct ly 20 can be taken

PV of Tax Saving On Depreciat ion (3.30)

PV of Salvage Value Adjusted For tax (2.25)

14.45

Calculation of Present Value (PV) of lease decision : - (Rs. lakh)

Particulars Years Amount PVF @8.4% PV

Lease Rent 0 -4 5.2 4.283 ( - ) 22.2716

Tax relief on lease 1 -5 1.56 3.950 6.162

(-)16.1096

(a)Calculation of Net Advantage of Leasing (NAL):

Part iculars (Rs. lakh)

Present Value of Out flow Under lease decision 16.1096

Present Value Out flow of borrowing& buying decision saved 14.45

Net Advantage of Leasing [Negat ive] -1.6596

Recommendation:Since Net Advantage of Leasing is negat ive the lease is financially not viable.

(b)Computation of Break Even Lease Rental (BELR)

14.45= L x [ 1+ PVAF (8.4%,4 years)] - [L x .30 x PVAF(8.4%,5 years] or 14.45 = [L x 4.283] -[.30L x 3.951]

or L = 4.66 Lakhs (approx)

AS PER ICAI: ICAI had recommended following solution for above question:

Workings:

(1)Calculation of annual installment :

20 lakh / 4,038 = Rs. 4.95 lakh 3.038* + 1 = 4.038

* PVIAF @ 12% for 4 years

(2)Calculation of tax shield or tax benefit on interest on debt: -(Rs. lakh)

Yr. Installment Opening Closing Principal Interest Tax

value value payment 12% shield

0 4.95 20.00 15.05 4.95 - -

1 4.95 15.05 11.90 3.14 1.80 0.54

2 4.95 11.91 8.38 3.52 1.43 0.43

3 4.95 8.39 4.45 3.94 1.00 0.30

4 4.95 4.45* - 4.45 0.52 0.16

* Balancing Figure

(3) Calculation of tax shield or tax benefit on depreciation: -

Year Opening value Closing value Depreciation Tax Saving @ 30%

1 20 16 4.00 1.20

2 16 12.80 3.20 0.96

3 12.80 10.24 2.56 0.77

4 10.24 8.19 2.05 0.62




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5 8.19 - 1.64 0.49

(4) Calculation of PV of Cash Outflow under borrowing and buying option

Year Installment Tax Shield on Interest Tax Shield on Dep. Net PVF PV

@ 8.4%

0 4.95 - - 4.95 1 4.95

1 4.95 0.54 1.20 3.21 0.922 2.96

2 4.95 0.43 0.96 3.56 0.851 3.03

3 4.95 0.30 0.77 3.88 0.785 3.05

4 4.95 0.16 0.62 4.17 0.724 3.02

5 - - 0.49 (0.49) 0.668 (0.33)

5 - - (2.00) 0.668 (1.336)

15.344

(5) Calculation of Present Value (PV) of lease decision : -

Particulars Years Amount PVF @8.4% PV

Lease Rent 0-4 5.2 4.282 (-) 22.27

Tax relief on lease 1 -5 1.56 3.95 6.16__

(-) 16.11

(a) Calculat ion of Net Advantage of Leasing (NAL):

Particulars (Rs. lakh)

Present Value of buying decision 15.344

Less: Present Value of lease decision -16.110

Net Advantage of Leasing - 0.766

Recommendation: Since Net Advantage of Leasing is negat ive the lease is financially not viable.

(a)Computation of Break Even Lease Rental (BELR) :

Let L be the BELR then

Present Value of lease rentals 4.282 L

Present Value of Tax shield on Lease Payment 3.95x 0.30 xL

3.097 L

Accordingly, BELR will be

3.097 L = Rs. 15.344 Lakh L = Rs. 4.954 Lakh i.e. Break Even Lease Rent

Note: Short Term Capital Loss on Salvage Value can also be considered.

QUESTION NO.7(Study M aterial) Out look Ltd., a small manufacturing firm, is considering the acquisit ion and

the use of a machine. After evaluat ing equipments offered by seven different manufacturers, it has come to the

conclusion that “ Z” was the most suitable machine for its needs. Consequent ly, it has asked the manufacturer ’s

sales personnel to provide informat ion on alternat ive financing plans available through their financing subsidiary.

The subsidiary presented the two alternat ives.

Alternative I was to lease the “ Z” equipment for 7 years, which was the machine’s expected useful life. The

annual lease payments would be Rs. 14,700 and would include service and maintenance. Lease payments would

be due at the beginning of the year. Lease payments would be fully tax-deduct ible.

Alternative II would be to purchase the “ Z” equipment through 100 per cent loan from the financing subsidiary.

The cost of the machine is Rs. 50,000. It would make seven annual payments of Rs. 9,935 each to repay the loan

of Rs. 50,000. Payments would be, at the end of each year.Rate of Interest is 9%

The company’s marginal tax rate in 44%. It has est imated that the equipment has in expected salvage value of Rs.

1,000. The company plans to depreciate the equipment by using straight-line method. The service and maintenance

would cost Rs. 3,700 annually.




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You are required to advice the company on the desirablity of the alternat ive plans.

Note : The relevant PVF are :

Year 0 1 2 3 4 5 6 7

PVF 1.00 .952 .907 .864 .823 .784 .746 .711

Q.7

Alternative I : Leasing Decision :

Year Lease Tax On Net PVF Present Value

Rent Lease rent Payment

0 14,700 - 14700 1.000 14700

1 14,700 6,468 8232 0.952 7,837

2 14,700 6,468 8232 0.907 7,466

3 14,700 6,468 8232 0.864 7,112

4 14,700 6,468 8232 0.823 6,775

5. 14,700 6,468 8232 0.784 6,454

6. 14,700 6,468 8232 0.746 6,141

7. — 6,468 (6468) 0.709 (4586)_______

Present Value of Cash Outflow 51,900(approx)

Note: Tax Saving on Lease Rent paid at the beginning has been taken at the beginning of the year only.

Alternative II : Buying Decision

Year Principal M ainten Interest Depreciation Total PVF

(1-t) (1-t) x Tax Rate CF @5.04% PV

1. 5,435 2072 2520 (3080) 6,947 0.952 6,614

2. 5,924 2072 2246 (3080) 7,162 0.907 6,496

3. 6,457 2072 1948 (3080) 7,397 0.864 6,391

4. 7,038 2072 1622 (3080) 7,652 0.823 6,298

5. 7,672 2072 1267 (3080) 7,931 0.784 6,218

6. 8,362 2072 801 (3080) 8,235 0.746 6,143

7. 9,112 2072 461 (3080) 8,565 0.711 6,090

7. Salvage (1,000) 0.711 (711) _____

Present Value of Cash Outflows 43,539_

Decision : Since the present value of cashflow is lowest for Alternat ive II, it is suggested to purchase the machine.

Working Note:Bifurcation of Interest & Principal Component

Year Instalment Interest Balance Principal

Payment Part Opening Part

1. 9,935 4,500 50,000 5,435

2. 9,935 4,011 44,565 5,924

3. 9,935 3,478 38,641 6,457

4. 9,935 2,897 32,184 7,038

5. 9,935 2,263 25,146 7,672

6. 9,935 1,573 17,474 8,362

7. 9,935 823 9,112 9,112

Note:Special attent ion should be given by student on Service & M aintenance Cost .The service & maintenance

cost is common under both the alternat ives.But this item should not be ignored as both are paid at different

period of t ime.

Lease Opt ion: Beginning of the year ; Loan Opt ion :End of the year




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QUESTION NO.8(Study M aterial) XYZ Co is planning to install a machine which becomes scrap in 3 years. It

requires an investment of Rs.180 lakhs and Net scrap realizes Rs. 18 lakhs. The company has following opt ions:

(1) to take a loan @ 18% and buy that machine, the loan being repayable in 3 equal year end installment s.

(2) take it on lease @ 444/1000 payable annually for 3 years.

Depreciat ion is 40% (WDV). Tax rate is 35%. Determine which opt ion is better.

Q.8

Pre tax rate is 18%.

Post tax rate is 18%(1-0.35) = 11.7 %.

(a) P.V. of lease rentals

Lease rental for Rs. 180 lakhs × 444/1000 = Rs. 79.92 lakhs p.a.

P.V. of LR = PVAF (11.7%,3) × Rs. 79.92 lakhs = 2.414 × Rs. 79.92 lakhs = Rs. 192.93 lakhs

(b) P.V. of tax saving on Lease Rent

Tax rate × amount = 0.35 × Rs. 79.92 lakhs = Rs. 27.97 lakhs per year

Present value of tax shield is PVAF(11.7%,3)×27.97 i.e.2.414 xRs.27.97=Rs. 67.52 lakhs

(c) P.V. of Depreciation

Depreciat ion for 1st year is 40% of Rs. 180 lakhs = Rs. 72 lakhs.

Depreciat ion for 2nd year is 40% of Rs. 108 lakhs = Rs. 43.20 lakhs

Depreciat ion for 3rd year is 40% of Rs. 64.80 lakhs = Rs. 25.92 lakhs

Depreciat ion tax shield = Rs. 72.0 lakhs × 0.35 = Rs.25.20 lakhs

= Rs.43.20 lakhs × 0.35 = Rs.15.12 lakhs

= Rs.25.92 lakhs × 0.35 = Rs.9.07 lakhs

P.V. of Depreciat ion tax saving

= 25.20 x PVF (11.7%,1) + 15.12 x PVF (11.7%,2) + 9.07 x PVF (11.7%,3) = Rs.41.18 lakhs

(d) PV of Salvage:

Salvage value is 18 lakhs after 3 years.

So P.V. of salvage in 3rd year is 18 × PVF (11.7%,3) = 12.92 lakhs

Analysis :

PV Of Cash Out flow Under Loan Opt ion = 180 - 41.18 - 12.92 = Rs. 125.90 Lakhs

PV Of Cash Out flow Under Lease Opt ion = 192.93 - 67.52 = Rs. 125.41 Lakhs

We should prefer Lease Opt ion

QUESTION NO.9(RTP) AGD Co is a profitable company which is considering the purchase of a machine cost ing

Rs. 32,00,000. If purchased, AGD Co would incur annual maintenance costs of Rs. 2,50,000.The machine would

be used for three years and at the end of this period would be sold for Rs. 5,00,000. Alternat ively, the machine

could be obtained under an operat ing lease for an annual lease rental of Rs. 12,00,000 per year, payable in

advance. AGD Co can claim depreciat ion @ 25% on WDV basis. Annual lease rental w ill be paid in the beginning

of each year.The company pays tax on profits at an annual rate of 30% and all tax liabilit ies are paid one year in

arrears.Charge no depreciat ion in year of sale.Required:

(1) Using an after-tax borrowing rate of 7%, evaluate whether AGD Co should purchase or lease the new machine.

(2) Suppose a bank had offered to lend AGD Co Rs. 32,00,000 for a period of five years interest payable is 5% for

every 6 month, then you are required to:

(i) Calculate the Annual Percentage Rate (APR) or Effect ive Rate p.a implied by the bank’s offer with interest

payable every six months.

(ii) Calculate the amount of installment payable at the end of each six-month period if the offered loan is to be

repaid in equal installments.

Q.9




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(1) Workings-

Tax benefits on Depreciation

Year Opening Depreciation Closing Tax Taken in

Value Value Benefit year [Note 1]

1 32,00,000 8,00,000 24,00,000 2,40,000 2

2 24,00,000 6,00,000 18,00,000 1,80,000 3

3 - - - - -

Note 1:It is clearly writ ten in quest ion that the company pays tax on profits at an annual rate of 30% and all tax

liabilit ies are paid one year in arrears and tax benefits are taken 1 year later.

Calculation Of Profit & Loss On Sale Of Asset:


Less:Depeciat ion Till Date 14,00,000

WDV 18,00,000

Less:Sale Value 5,00,000_

Loss On Sale Of Asset at the end of year 3 13,00,000

Tax Saving On Loss at year end 4 13,00,000 x 30% =Rs.3,90,000

Purchase Evaluation

Year 0 Year 1 Year 2 Year 3 Year 4

Acquisit ion/

Disposal (32,00,000) 5,00,000

Tax Benefit on

Depreciat ion 2,40,000 1,80,000 3,90,000

M aintenance Cost (2,50,000) (2,50,000) (2,50,000)

Tax benefit of

M aintenance Cost 75,000 75,000 75,000

Cash Flow (32,00,000) (2,50,000) 65,000 5,05,000 4,65,000

PVF@7% 1.00 0.935 0.873 0.816 0.763

PV (32,00,000) (2,33,750) 56,745 4,12,080 3,54,795

PV of Purchase Opt ion = Rs. 26,10,130

Lease evaluation

Year 0 Year 1 Year 2 Year 3 Year 4

Lease Rental (12,00,000) (12,00,000) (12,00,000)

Tax Benefit on

Lease Rental 3,60,000 3,60,000 3,60,000

Cash Flow (12,00,000) (12,00,000) (8,40,000) 3,60,000 3,60,000

PVF@7% 1.00 0.935 0.873 0.816 0.763

PV (12,00,000) (11,22,000) (7,33,320) 2,93,760 2,74,680

PV of leasing Opt ion = Rs. 24,86,880

Decision:Since out flow is less in case of leasing opt ion the company should opt for the same.

(2) (i) Int erest payable every six months means that the bank will require 5% every six months accordingly

equivalent annual percentage rate shall be calculated as follows:[(1+ ·05)2 – 1] x 100 = 10·25%

(ii) Amount of installment to be paid every 6 month will be :

= Rs. 32,00,000/ PVAF (5%,10 periods) i.e 7·722 = Rs. 4,14,400




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1.1_____ can be defined as a right to use equipment or capital goods on payment of periodical amount .

(a)Lease (b)Hire Purchase (c)Factoring (d)Forfait ing

2. ____ is the actual owner of equipment permit t ing use to the other party on payment of periodical amount .

(a) Lessor (b) lessee (c)Factor (d)None of the above

3. Who acquires the right to use the equipment on payment of periodical amount?

(a)Lessor (b) lessee (c) Factor (d) None of the above

4. In which of the following opt ions the user of the asset is the owner of the asset?

(a)Lessor (b) lessee

5. Which of the following is a type of lease?

(a) Operat ing Lease (b)Financiaal Lease (c) Sales-Aid Lease (d) All of these

6. In which of the following lease, besides the cost of machinery, the lessor also bears insurance, maintenance

and repair costs etc.

(a) Operat ing Lease (b)Financial Lease (c) Sales-Aid Lease (d) Sales and Lease

back

7. Operat ing Lease agreements may generally be preferred by the lessee in which of t he follow ing circum-

stances:

(a) When the long-term suitability of asset is uncertain.

(b) When the asset is subject to rapid obsolescence.

(c) When the asset is required for immediate use to t ide over a temporary problem

(d) all of the above

8. In which of the following laese, the lessee bears insurance, maintenance and repair costs etc.

(a) Operat ing Lease (b) Financial Lease (c) Sales-Aid Lease (d) Sales and Lease

back

9. The lessor may not be a single individual but a group of equity part icipants and the group borrows a large

amount from financial inst itut ions to purchase the leased asset . Such t ransact ion is called '

(a)Leveraged lease. (b) Operat ing Lease (c) Financial Lease (d) Sales-Aid Lease

10. A method of raising funds immediately required by lessee for working capital or other purposes is:

(a) Operat ing Lease (b) Financial Lease (c) Sales-Aid Lease (d) Sales and Lease

back

11. In short -term lease (operat ing lease) _______ is/ are safeguarded against the risk of obsolescence

(a) Lessor (b) Lessee (c) Both (d) None of the above

12.Which of the following are benefits of Leasing:

(a) By employing 'sale and lease back' arrangement , the lessee may overcome a financial crisis by immediately

arranging cash resources for some emergent applicat ion or for working capital.

(b) Piecemeal financing of small equipments is convenient ly possible through lease arrangement only as debt

LEASING -EPQ




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financing for such items is impract icable.

(c) Tax benefits may also somet imes accrue to the lessee depending upon his tax status.


13. Which of the above statements are t rue?

(a) Lessor generally obtain credit facilit ies from banks etc. to purchase the leased equipment which are subject

to hypothecat ion charge in favour of the bank. Default in payment by the lessor may somet imes result in seizure

of assets by banks causing loss to the lessee.

(b)Lease financing has a very high cost of interest as compared to interest charged on term loans by financial

inst itut ions/ banks.

(c)Bothof the aabove

(d) Non of the above

14. There are three methods of evaluat ing a leasing proposal, which of theses three are correct?

(a) Present Value analysis (b) Internal Rate of Return analysis

(c) The Bower Herringer Williamson method (d) All of these

15. In which of the following methods, " the present value of the annual lease payments (tax adjusted) is com-

pared with that of the annual loan repayments adjusted for tax shield on depreciat ion and interest "


(c)The Bower Herringer Williamson method (d) Account ing Rate of return method

16. Which method seeks to establish the rate at which the lease rentals, net of tax shield on depreciat ion are

equal to the cost of leasing?


(c) The Bower Herringer Williamson method (d) Account ing Rate of return method

17. Related cash flows can be discounted both at which rate

(a) Post Tax Cost of Debt (b) Cost of Capital (c)None of the above (d)Any of the above

18. The various types of Cash flows involved in financing decisions are :

(a) Init ial Cash Out flow (b)Annual Cashflow (c) Terminal Cash flow (d) All of the above

19. BELR means

(a) Break even lease rentals (b) Break even lease rate

(b) Break even level of rentals forlessor (d)Break even level of rentals for lessee

20. The _________ involved is disposal/ salvage value of the asset financed net of Tax Adjustment on Short Term

Capital Loss or Gain, if any.

(a)Init ial Cash Out flow (b)Annual Cashflow (c)Terminal Cash flow (d) All of the above

21. _______________ has been widely used in some European count ries, to arbit rage the difference in the tax

laws of different count rie.

(a)Cross-border leasing (b) Financiaal Lease (c)Sales-Aid Lease (d)Sales and Lease

back

22. important object ives of cross border leasing include the following:

(a) The lessor can ut ilize very favourable " leveraged lease" financial account ing t reatment for the overall t rans-




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act ion.

(b) In some count ries, it is easier for a lessor t o repossess t he leased equipment following a lessee default

because the lessor is an owner and not a mere secured lender.

(c) Leasing provides the lessee with 100% financing.

(d) All of the above.

23. The principal players are

(a) one or more equity investors;

(b) a special purpose vehicle formed to acquire and own the equipment and act as the lessor;

(c) one or more lenders, and the lessee.


24. In order for the lessor to obtain the tax benefits associated with equipment leasing, most count ries require

that the lease be t reated as a __________ for tax purposes

(a) " t rue lease" (b) Full lease (c) Part ial Lease (d) Financial Lease

25. While details may differ from one t ransact ion to another, in cross border leasing most leasing st ructures are

essent ially similar and follow the _________ pat tern

(a) sale-leaseback (b) Operat ing Lease (c) Financiaal Lease (d) Sales-Aid Lease

26. As per Sect ion 45-IA of the said Act , no non-banking financial company shall commence or carry on t he

business of a non-banking financial inst itut ion without :-

(a) obtaining a cert ificate of regist rat ion issued under this Chapter; and

(b) having the net owned fund of twenty-five lakh rupees or such other amount , not exceeding two hundred lakh

rupees, as the RBI may, by not ificat ion in the Official Gazette, specify

(c) Either (a) or (b)

(d) Both (a) and (b)

27. An Equipment Leasing Company has been an ______

(a) eligible NBFC (b) Not eligible NBFC

28. ______________ means any company which is a financial inst itut ion carrying on as its principal business, the

act ivity of leasing of equipment

(a) Equipment Leasing (EL) (b) Operat ing Lease (c) Financiaal Lease (d)Sales-Aid Lease

ANSW ER:

1.a ; 2.a ; 3.b ; 4.a ;5.d ; 6. a ; 7.d ; 8.b ; 9.a ; 10.d ; 11.b ; 12.d ; 13.c ; 14.d ; 15.a ; 16.b ; 17.d ; 18.d ; 19.a ;

20.c ;21.a ;22.d ; 23.d ; 24.a ; 25.a ; 26.d ; 27.a ; 28.a

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