Pinnacle Academy. Solutions of Tests of April 2015 Batch

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1 Pinnacle Academy Solutions of Tests of April 2015 Batch , Florence Classic, Besides Unnati Vidhyalay, Jain Derasar Road, Ashapuri Society, Akota, Vadodara-20. ph: Solution of Test of Leasing [SFM CA Final] Conducted on 22 nd August 2015 [Solution is at the end with marking for self-assessment] Time Allowed-1 hour Maximum Marks- 30 Q 1 A mechanized feed spreader costs Rs.8,00,000. It has useful life of 5 years at the end of which it has salvage value of Rs.1,00,000. The full cost of the asset shall be written off over the useful life of 5 years and the same shall be admissible for tax. Tax rate is 30%. A lease arrangement calls for lease payments of Rs.1,90,000 in advance annually. Alternatively, funds can be borrowed at 10% and loan repaid in equal annual instalments in advance. Using the IRR method, recommend the best alternative. Q 2 A customer of ABC Leasing company has expressed desire to acquire a machine on lease on terms that lease rent shall be paid in the ratio of 3:2:1. The sale value of the machine is Rs.600 lakhs and depreciation shall be charged by following SLM. If required return is 10% calculate lease rents for three years. Tax rate is 35%. Q 3 Pure Drinks is considering the acquisition of a machine to manufacture a new flavored fruit pulp health drink. The cost of the machine is Rs.1,250 lakhs. Pure Drinks can either outrightly buy the machine or acquire it on finance lease. Bank is ready to provide 100% finance to Pure Drinks at an interest rate of % and repayable in five equal annual installments payable at the end of each year. 1

2 The tax rate for the company is 35%. Downloaded from The machine can also be acquired by paying in advance lease rent of Rs.350 lakhs each year for five years. The useful life of the machine is five years at the end of which it shall revert back to the lessor. The machine shall have salvage value of Rs.10 lakhs at the end of 5 th year. It shall be depreciated by Pure Drinks following the straight line method. You are required to calculate Net Advantage of Leasing (NAL) and recommend the method of acquiring the machine. Cost of Capital is 12%. (Assessed answer papers shall be returned latest by 12 th September 2015) 2

3 Solution of Test of Leasing Conducted on 22 nd August 2015 Q 1 Determination of Post-tax cost of Leasing in % as per IRR Method: Year Lease Rent Tax shield on Lease Depre- Rent ciation Add nl Tax Shield On Lease Net Cash Out Flows PVF (10%) PV (10%) PVF (11%) PV (11%) Rent 0 1,90, ,90, ,90, ,90, ,90,000 57,000 48,000 9,000 1,81, ,73, ,61, ,000 48,000 9,000 (9,000).621 (5,589) (5,346) 5 Salvage Value foregone (1,00,000 30%) 70, , ,580 8,01,651 7,87,696 NPV at 10% = 8,00,000 8,01,651 = (Rs.1,651) NPV at 11% = 8,00,000 7,87,696 = Rs.12,304 Post-tax Cost of leasing = ,651 / - 1,651 12,304 X 1 = % Post-tax Cost of borrowing = 10 (1 -.3) = 7% Recommendation: Borrowing alternative in view of lower cost. (7 marks) Note: Q 2 Full cost is required to be written off. Depreciation = 8,00,000 / 5 = Rs.1,60,000. Salvage value available under borrowing alternative is foregone in leasing. Hence, treated as opportunity cost after deducting STCG 30% as entire cost of the asset has been written off. Let lease rent be Rs. X in third year. Calculation of PV from Lease Rent: Year Lease Tax Net PVF PV Rent (35%) Cash Inflow (10%) 1 3X 1.05X 1.95X X 2 2X 0.7X 1.30X X 3 X.35X 0.65X X X PV of total tax shield on depreciation = (600 / 3) X 35 % X PVF (10%, 3) = 70 X = Rs lakhs 3

4 Total PV of cash flows from leasing = X Lease rent should be so charged that cost of the asset should be recovered. i.e. 600 = X i.e. X = Rs lakhs. Q 3 Thus, lease rent in three years is Rs lakhs, Rs lakhs and Rs lakhs. (1 mark) Discount rates used: Lease Rent: Pre-tax cost of debt i.e % Tax shields and salvage value: WACC of lessee i.e. 12 % Calculation of Net Advantage of Leasing (NAL): Amount (Rs.) Benefits of Leasing: Cost of Machine Saved PV of tax shield on lease rent paid (350 X 35% X 3.605*) Leasing Benefits (A) Costs of Leasing: PV of Lease Rent Paid (350 X 3.923**) PV of Depreciation foregone (248 X 35% X 3.605*) PV of Salvage Value foregone (10 X 0.567***) 5.67 PV of tax shield on interest foregone (WN # 2) Leasing Costs (B) NAL (A B) (151.39) * at 12% for 1 to 5 ** at % for 0 to 4 *** at 12% for 5 th Working Notes: (i) Equated Annual Installment = 1250 / = lakhs (ii) PV of tax shield on interest foregone: Year Amount o/s Interest Tax Shield PVF PV at 35% (12%) Recommendation: Machine should be purchased in view of negative NAL. Solution prepared by CA. Ashish Lalaji 4

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