Question 11.I.15: The Hypothetical Industries Ltd (HIL) has an investment plan......
The Hypothetical Industries Ltd (HIL) has an investment plan amounting to Rs 108 lakh. The tax relevant rate of depreciation of the HIL is 25 per cent, its marginal cost of capital and marginal cost of debt are 16 per cent and 20 per cent respectively and it is in 35 per cent tax bracket.
\, It is examining financing alternatives for its capital expenditure. A proposal from the Hypothetical Finance Ltd (HFL), with the following salient features, is under its active consideration:
\, Hire Purchase Plan: The (flat) rate of interest charged by the HFL is 16 per cent. Repayment of the amount is to be made, in advance, in 36 equated monthly instalments. The hirer/hire purchaser is required to make a down payment of 20 per cent.
\, Leasing Alternative: Lease rentals are payable @ Rs 28 ptpm, in advance. The primary lease period can be assumed to be 5 years.
\, Assume that the SOYD method is used to allocate the total charge for credit under the hire purchase plan. The net salvage value of the equipment after 3 years can be assumed to be Rs 33 lakh.
\, Which alternative—leasing or hire purchase—should the HIL use? Why?
The choice will depend on the relative cost of hire purchase and leasing
Working Notes
1. Down payment = Rs 108 lakh × 0.20 = Rs 21.6 lakh
2. Monthly hire purchase instalment = [Rs 86.4 lakh (Rs 108 lakh less 20 per cent down payment ) + (Rs 86.4 lakh × 0.16 × 3 years)] ÷ 36 = Rs 3.552 lakh
\, Present value of monthly hire purchase instalment
\, = Rs 3.552 lakh × 12 × \frac{I}{d^{(12)}} × PVIFA (20,3) where I = 0.20
\, = (Rs 3.553 lakh × 12) × 2.106 × 1.105 = Rs 99.19 lakh
3. Present value of depreciation tax shield:
\, = [Rs 27 lakh × PVIF (16,1) + Rs 20.25 lakh × PVIF (16,2) + Rs 15.19 lakh ×
\, PVIF (16,3) + Rs 11.39 lakh × PVIF (16,4) + Rs 8.54 lakh × PVIF (16,5)] × 0.35
\, = [(27 × 0.862) + (20.25 × 0.743) + (15.19 × 0.641) + (11.39 × 0.552) + (8.54 ×
\, 0.476)] × 0.35 = Rs 20.44 lakh
Working Notes
1. Present value of lease payments:
\, = [Rs 108 lakh × 0.028 × 12) × \frac{I}{d^{(12)}} × PVIFA (20,5)], where I = 0.20
\, = Rs 108 lakh × 0.028 × 12 × 1.105 × 2.991 = Rs 119.93 lakh
2. Present value of tax shield on lease payment = [Rs 108 lakh × 0.028 × 12 ×
\, PVIFA (16,5) × 35
\, = (Rs 36.29 lakh × 3.274)] × 0.35 = Rs 41.58 lakh
3. Present value of tax shield on charge for credit:
\, Total charge for credit = Rs 108 lakh × 0.80 × 0.16 × 3 = Rs 41.47 lakh
Present value of tax shield = [(Rs 22.79 × 0.862) + (Rs 13.82 × 0.743) + (Rs 4.86 × 0.641)] ´ 0.35
\, = Rs 11.56 lakh
Decision Since the cost of leasing exceeds the cost of hire purchase, the HIL should acquire the equipment from the HFL under the hire purchase plan.
Cost of Hire Purchase (CHP) (Rs lakh)
| Rs 21.60 | 1 Down payment (working note 1) |
| 99.19 | 2 Plus Present value of monthly hire-purchase instalment (working note 2) |
| 20.44 | 3 Minus present value of depreciation tax shield (working note 3) |
| 15.70
|
4 Minus present value of net salvage value |
| 84.65 | Total |
Cost of Leasing (COL) (Rs lakh)
| Rs 119.93 | 1 Present value of lease payments (working note 1) |
| 41.58 | 2 Minus present value of tax shield on lease payment (2) |
| 11.56
|
3 Plus Present value of tax shield on charge of credit (3) |
| 89.91 | Total |
Allocation of total charge for credit; SOYD method
| Annual\>charge\>(Rs\>lakh) | SOYD\>factor | Year |
| 22.79 | \frac{36+ 35+ … +25}{36+ 35+ … +1}=\frac{366}{666} | 1 |
| 13.82 | \frac{24+23+…+16}{36+ 35+ … +1}=\frac{222}{666} | 2 |
| 4.86 | \frac{12+ 11+ … +1}{36+ 35+ … +1}=\frac{366}{666} | 3 |