Question 11.I.16: For the HFL in Illustration 11.15, assume the following: • F......
For the HFL in Illustration 11.15, assume the following:
• Front-end (advance) cost of structuring the deal: 0.5 (half) per cent of the amount financed
• Marginal cost of debt: 20 per cent
• Marginal cost of equity: 25 per cent
• Target long-term debt-equity ratio: 4:1
• Marginal tax rate: 35 per cent
• Residual value under lease plan: 10 per cent of the investment cost
Required: Which plan—hire purchase or lease—is financially more attractive to the HFL? Why?
Working Notes
Marginal cost of capital [0.80 × 0.20 × 0.65] + [0.20 × 0.25] = (0.104 + 0.05) = 15.4 per cent
1. Monthly hire purchase instalment = [(Rs 86.4 lakh + (Rs 86.4 lakh × 0.16 × 3)] ÷ 36 = Rs 3.552 lakh
\, Present value of monthly hire-purchase instalments:
\, = Rs 3.552 lakh × PVIFA_\mathrm{m} (15.4,3)
\, = Rs 3.552 lakh × 12 × 2.265 × 1.082 = Rs 104.46 lakh
2. Present value of tax shield on initial direct cost:
\, Initial direct cost (0.5 per cent of Rs 86.4 lakh) = 0.432 lakh
\, Present value = Rs 0.432 lakh × 0.866 × 0.35 = Rs 0.13 lakh
3. Present value of interest tax on hire purchase related income:
\, Unexpired finance income (total charge for credit) at inception = Rs 86.4
\, lakh × 0.16 × 3 = Rs 41.47 lakh
Present value = (Rs 0.46 lakh × 0.866) + (Rs 0.28 lakh × 0.751) + (Rs 0.10 lakh × 0.648) = Rs 0.67 lakh
\, 4. Present value of income tax on net finance income:
\, = (Rs 7.82 lakh × 0.866) + (Rs 7.74 lakh × 0.751) + (Rs 1.67 lakh × 0.648) = Rs 11.41 lakh
Working Notes
1. Present value of lease rentals = Rs 108 lakh × 0.028 × 12 × PVIFA (15.4, 5)
\, = Rs 108 lakh × 0.028 × 12 × 1.082 × 3.313 = Rs 130.08 lakh
2. Present value of depreciation tax shield = [Rs 27 lakh × PVIF (15.4,1) + Rs
\, 20.25 lakh × PVIF (15.4,2) + Rs 15.19 lakh × PVIF (15.4,3) + Rs 11.34 lakh ×
\, PVIF (15.4,4) + Rs 8.55 lakh × PVIF (15.4,5)] × 0.35 = [Rs 27 lakh × 0.866) +
\, (Rs 20.25 lakh × 0.751) + (Rs 15.19 lakh × 0.648) + (Rs 11.34 lakh × 0.562) +
\, ( Rs 8.55 lakh × 0.482)]
\, = Rs 20.62 lakh
3. Present value of tax shield on initial direct cost:
\, = 0.54 lakh (0.5 per cent of Rs 108 lakh) × PVIF (15.4,1) × 0.35 = Rs 0.16 lakh
4. Present value of residual value = Rs 10.80 lakh (0.10 × Rs 108 lakh) × PVIF
\, (15.4,5) = Rs 5.21 lakh
5. Present value of income tax on lease rentals = Rs 108 lakh × 0.028 × 12 ×
\, PVIFA (15.4,5) × 0.35
\, = (Rs 36.29 lakh × 3.314) × 0.35 = Rs 42.09 lakh
\, As the present value of hire purchase (Rs 5.68 lakh) exceeds the net present value of leasing (Rs 5.44 lakh), the hire purchase plan is financially more attractive to the HFL.
A (i) Net Present Value of Hire Purchase Plan (Rs lakh)
| 104.46 | 1 Present value of monthly hire-purchase instalment (working note 1) |
| 0.13 | 2 Plus present value of tax shield on initial direct costs (working note 2) |
| 86.40 | 3 Less amount financed (Rs 108 lakh – Rs 21.60 lakh, down payment) |
| 0.43 | 4 Less initial direct cost (0.5 per cent of Rs 86.4 lakh) |
| 0.67 | 5 Less present value of interest tax on hire purchase-related income \, (working note 3) |
| 11.41 | 6 Less present value of income tax on net finance income (working note 4) |
| 5.68 | Total |
Allocation of unexpired finance income, based on the SODY method (Rs lakh)
| Annual\>charge\>(Rs\>lakh) | SOYD\>factor | Year |
| 22.79 | \frac{36+ 35+ … +25}{36+ 35+ … +1}=\frac{366}{666} × Rs 41.47 lakh | 1 |
| 13.82 | \frac{24+23+…+13}{36+ 35+ … +1}=\frac{222}{666} × Rs 41.47 lakh | 2 |
| 4.86 | \frac{12+ 11+ … +1}{36+ 35+ … +1}=\frac{78}{666} × Rs 41.47 lakh | 3 |
Interest tax and income tax on annual finance income (Rs lakh)
| Income\>tax\>(0.35) | Net\>finance\>income | Interest\>tax\>(2%) | Gross\>Finance\>Income | Year |
| 7.82 | 22.33 | 0.46 | 22.79 | 1 |
| 4.47 | 13.54 | 0.28 | 13.82 | 2 |
| 1.67 | 4.76 | 0.10 | 4.86 | 3 |
A (ii) Net Present Value of Leasing (Rs lakh)
| 130.08 | 1 Present value of lease rentals/receipts (working note 1) |
| 20.62 | 2 Plus present value of depreciation tax shield (note 2) |
| 0.16 | 3 Plus Present value of tax shield on initial direct cost (note 3) |
| 5.21 | 4 Plus Present value of residual value (note 4) |
| 108.00 | 5 Less Initial investment |
| 0.54 | 6 Less Initial direct cost |
| 42.09 | 7 Less Present value of income tax on lease rentals (note 5) |
| 5.44 | Total |