ABC Ltd. is a firm that specializes in providing software services to its clients. In order to augment its time-share computer services to its clients, the firm is considering the purchase of an additional computer.In th

CS Executive · Financial and Strategic Management · PYQS · June 2019
ABC Ltd. is a firm that specializes in providing software services to its clients. In order to augment its time-share computer services to its clients, the firm is considering the purchase of an additional computer.In this context, it has two alternatives, as mentioned below:(i) Purchasing the computer in lieu of making a payment of ₹24,00,000.(ii) Entering into a lease agreement with a company with the following necessary terms and conditions:(a) The computer has to be leased for a period of 3 years for ₹6,00,000 as annual lease rent in addition to 15% of the revenue accruing from gross time-share service.(b) An additional payment of ₹5,00,000 needs to be done at the end of the third year.(c) Payments as lease rent need to be made at the year end.(d) After the completion of the specified period in the contract, the computer needs to be handed back to the lessor.As per the company estimates, the computer under review, presently will have a worth of ₹12 lakhs at the end of the third year with the forecast revenues as follows: Year ₹ 1 24,00,000 2 25,50,000 3 28,00,000 Other relevant details are as follows:(i) The Annual operating costs (excluding the depreciation/lease rent of the computer) are ₹10,00,000 as per estimates with an additional ₹2,00,000 being involved in start-up and training costs at the beginning of the first year.(ii) The aforesaid costs are to be borne by the lessee ABC Ltd. Further, the lessee will borrow at an interest rate of 15% to finance the acquisition of the computer. Repayments for the same have to be done as per the schedule specified below: Year-end Principal (₹) Interest (₹) Total (₹) 1 6,00,000 3,60,000 9,60,000 2 9,00,000 2,70,000 11,70,000 3 9,00,000 1,35,000 10,35,000 In order to depreciate its assets, ABC Ltd. employs the straight line method and makes a payment of 50% tax on its income.You, as a company secretary, are approached by ABC Ltd. to give advice regarding the choice of the more beneficial alternative, with proper and justified reasons.Consider Present Value Factor at 9% Year Present value factor at 9% Present value factor at 15% 1 0.917 0.870 2 0.842 0.756 3 0.772 0.658

Answer & Explanation:

Evaluation of Lease Alternative: Annual Lease Rent = ₹6,00,000 Revenue from gross time-share service: Year 1: ₹24,00,000 Year 2: ₹25,50,000 Year 3: ₹28,00,000 Additional Lease Rent (15% of revenue): Year 1: 15% of ₹24,00,000 = ₹3,60,000 Year 2: 15% of ₹25,50,000 = ₹3,82,500 Year 3: 15% of ₹28,00,000 = ₹4,20,000 Lump sum payment at end of Year 3 = ₹5,00,000 Tax Rate = 50% Discount Rate (Post-tax cost of debt) = 9% (since the lessee borrows at 15% and tax rate is 50%, the post-tax cost of debt is 15% * (1-0.50) = 7.5%. However, the problem provides PV factors at 9% and 15%. The solution uses 9% for PV factor, which implies it's the relevant discount rate for cash outflows. Let's follow the solution's approach.) Present Value of cash outflows under lease alternative: Year Lease Rent (₹) 15% Gross Revenue (₹) Lump sum payment (₹) Total Payment (₹) Tax Shield @ 50% on lease (₹) Net Cash Outflows (₹) PV factor at 9% Total PV (₹) 1 6,00,000 3,60,000 - 9,60,000 4,80,000 4,80,000 0.917 4,40,160 2 6,00,000 3,82,500 - 9,82,500 4,91,250 4,91,250 0.842 4,13,632.50 3 6,00,000 4,20,000 5,00,000 15,20,000 7,60,000 7,60,000 0.772 5,86,720 Total PV of Cash Outflows (Lease) 14,40,512.50 Evaluation of Buying/Borrowing Alternative: Initial Purchase Cost = ₹24,00,000 Life of computer = 3 years Salvage Value at end of Year 3 = ₹12,00,000 Depreciation (Straight Line Method) = (Cost - Salvage Value) / Life = (₹24,00,000 - ₹12,00,000) / 3 = ₹12,00,000 / 3 = ₹4,00,000 per year Tax Rate = 50% Tax Savings on Depreciation = 50% of ₹4,00,000 = ₹2,00,000 per year Borrowing Interest Rate = 15% Discount Rate (Post-tax cost of debt) = 9% Present Value of cash outflows under Buying/Borrowing alternative: Year Principal (₹) Interest (₹) Total Installment (₹) Tax advantage on Interest (₹) Tax advantage on Depreciation (₹) Net Cash Outflows (₹) PV factor at 9% Total PV (₹) 1 6,00,000 3,60,000 9,60,000 1,80,000 2,00,000 5,80,000 0.917 5,31,860 2 9,00,000 2,70,000 11,70,000 1,35,000 2,00,000 8,35,000 0.842 7,03,070 3 9,00,000 1,35,000 10,35,000 67,500 2,00,000 7,67,500 0.772 5,92,510 Subtotal 18,27,440 3 Salvage Value (₹12,00,000) (12,00,000) 0.772 (9,26,400) Total PV of Cash Outflows (Buy) 9,01,040 Note: The annual operating costs (₹10,00,000) and start-up/training costs (₹2,00,000) are common to both alternatives and thus irrelevant for the decision. They are not included in the calculation of cash outflows. Recommendation: The Present Value of cash outflows under leasing is ₹14,40,512.50, which is more than the Present Value of cash outflows under buying/borrowing of ₹9,01,040. Therefore, the company is advised to opt for the buying/borrowing alternative as it results in lower present value of cash outflows, making it the more beneficial option.

Topics: Financial Management

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