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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-TH EORY

1. INTRODUCTION TO FACTORING

This concept has not been fully developed in our count ry and most of their w ork is done by companies t hemselves.
All unit s’ part icularly small or medium size unit s have t o make considerable effort s t o realize t he sale proceeds
w it hout much success creat ing funct ional difficult ies for such unit s.
M any unit s under small-scale sect or have become sick only because of delay/ non-realizat ion of t heir dues
from large unit s. Int roduct ion of fact oring services w ill, t herefore, prove very beneficial for such unit s as it w ill
free t he unit s from hassles of collect ing receivables t o enable t hem t o concent rat e on product development and
market ing.

2.DEFINITION AND M ECHANISM

2.1Definition and Concept

Basically, fact oring is a kind of financial service in w hich a business organizat ion sells it s Account Receivables
t o anot her person, called a fact or, at a discount in order t o raise money. Fact oring is different from bill discount ing.
In bill discount ing invoice are discount ed at a cert ain rat e t o get t he funds, w hereas t he concept of fact oring is
broader. In t he fact oring process, t he Account Receivables are sold t o an out side agency.
Example - The seller sold good on credit and raised t he invoice. How ever, t he seller needs immediate money t o
meet it s w orking capit al requirement s i.e. meet ing day t o day expenses of t he business. For t his purpose, he sold
t he goods to an out side agency i.e. a fact or. The fact or pays t he required amount t o t he seller after some deduct ing
some amount . So, t he ent ire invoice amount is not paid by t he fact or. Rat her, about 70-80% of t he bill amount is
paid by t he fact or. The remaining amount is paid after the fact or receives t he ent ire bill amount from the cust omers
(debt ors). The fact or charges some commission for providing t hese services.
The st udy group appointed by t he Internat ional Inst it ute for t he Unificat ion of Private Law (UNIDROIT), Rome,
during 1988, recommended, in general t erms, t he definit ion of fact oring as under:
“ Fact oring means an arrangement bet w een a fact or and his client w hich includes at least t w o of t he follow ing
services t o be provided by t he fact or:
• Finance • M aint enance of debt • Collect ion of debt s • Prot ect 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) t o t rade or professional debt ors;
(iii) w hen not ice of assignment has been given t o t he debt ors. Domest ic fact oring is not yet a w ell-defined concept
and it has been left t o t he discret ion of legal framew ork as w ell as t rade usage and convent ion of t he individual
count ry. In India fact oring is undertaken by different bank subsidiaries like SBI Fact ors and Commercial Services
Lt d. Promot ed by SBI and Canara Bank Fact ors Lt d. promot ed joint ly by Canara Bank, Andhra Bank and SIDBI.

2.2M echanism of Factoring

In a fact oring t ransact ion, t here are t hree part ies - t he fact or, t he client and t he cust omers of t he client . The
client is t he person w ho is act ually availing t he fact oring service. The fact or providest he fact oring services and
t he cust omers are t he persons w ho purchases t he 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) Cust omer places an order w it h t he client for purchase of goods and/ or services on credit .
(ii) On t he basis of agreement , t he client delivers t he goods and sends t he invoice t o cust omers.
(iii) The client t hen assigns t he invoice t o t he fact or. This is generally called, “ Call sale of book debt s by t he client
firm t o t he fact or.”
(iv) The fact or, t hen, makes prepayment up t o 80 per cent of t he invoice value t o t he client .
(v) The client pays interest on advances of amount received unt il t he cash is collected from cust omer.
(vi) The fact or maint ains account s receivable of t he client and sends periodical st at ement s t o t he cust om er t o
accelerat e t he collect ion.
(vii) On t he due date, t he fact or collect s t he invoice amount from t he cust omer.
(viii) Aft er t hat , t he fact or releases t he remaining amount t o t he client aft er adjust ing his commission/ fees.

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

Suppose Cust omer/ Client has raised an order w it h an invoice value of ` 500000; basis t hat order business
delivered t he product on credit basis. Aft er t his, t he business sells t he invoice t o fact oring company t o get at
least 80 per cent realized value i.e. ` 400000.
This realized value can be used for furt her business expansion or any product development . The business pays
an int erest i.e. 5% on t he advance of ` 400000 unt il amount realized from client . Then fact oring company collect s
t he invoice amount from cust omer i.e ` 500000. Aft er t his fact oring company releases t he reserve amount i.e. `
1,00,000 less 5% int erest charged.In t his Debt or financing process, fact oring charges also played a vit al role for
providing t he services.

The following factoring charges are levied:

• Finance charges - Computed on t he prepayment out standing in t he client ’s a/ c at mont hly intervals. Finance
charges are only for financing t hat has been availed by t he client . These charges are similar t o int erest levied on
t he cash credit facilit ies in a bank.
• Service fee - It is a nominal charge at mont hly int erval t o cover t he cost services namely - collect ion, M IS
report s, sales ledger management etc. Service fee is determined on the basis of tot al gross value, no. of cust omers,
degree of credit risk et c.

3.TYPES/ FORM S OF FACTORING

Depending upon t he feat ures built int o t he fact oring arrangement t o cat er t o t he varying needs of t rade/
cit izens, there can be different kinds of factoring:

(i)Recourse and Non-recourse Factoring: Under a recourse fact oring arrangement , t he fact or has recourse t o
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t he client (firm) if t he debt purchased/ receivable fact ored t urns out t o be irrecoverable. In ot her w ords, t he fact or
does not assume credit risks associat ed w it h t he receivables.In case of non-recourse fact oring, t he fact or does
not have t he right t o recourse. The loss arising out of irrecoverable receivables is borne by t he fact or, as a
compensat ion for w hich he charges a higher commission.

(ii)Advance and M aturity Factoring: In advance fact oring, t he fact or paid a pre specified port ion, ranging bet ween
t hree-fourt hs t o nine t ent hs, of t he fact ored receivables in advance, t he 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 as
soon as t he fact ored debt s are approved/ t he invoices are accounted for. The client has t o pay interest (discount )
on t he advance/ repayment bet ween the date of such payment and the date of actual collect ion from the customers/
or t he guaranteed payment dat e, det ermined on t he basis of t he prevailing short -t erm rat e, t he financial st anding
of t he client and t he volume of t he t urnover.In mat urit y fact oring, t he fact oring agency does not provide any
advance to t he firm. In fact , t he fact or makes payment t o his client after collect ing t he amount from t he cust omers
at t he end of t he mat urit y period.

(iii)Full Factoring: This is t he most comprehensive form of fact oring combining t he feat ures of all t he fact oring
services specially t hose of non-recourse and advance fact oring. It is also know n as Old Line Fact oring.

(iv)Disclosed and Undisclosed Factoring: In Disclosed Fact oring, t he name of t he fact or is disclosed in t he
invoice by t he supplier-manufact urer of t he goods asking t he buyer t o make payment t o t he fact or.
How ever, in Undisclosed Fact oring, t he name of t he fact or is not disclosed in t he invoice alt hough t he fact or
maint ains t he sales ledger of t he supplier-manufact urer. The ent ire realizat ion of t he business t ransact ion is
done in t he name of t he supplier company but all cont rol remains w it h t he fact or.

(v)Dom estic and Export/ Cross Border Factoring: If t he t hree part ies involved, nam ely, cust om er (buyer),
client ,(seller-supplier) and fact or (financial int ermediary) are domiciled in t he same count ry t hen it is know n as
domest ic fact oring. There are usually four part ies involved in a cross border fact oring t ransact ion. They are:
a) Export er (client ) b) Import er (cust omer) c) Export fact or d)Import Factor
[It is also know n as t w o-fact or syst em]

4.FUNCTIONS OF A FACTOR

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

• M aintenance/ administration of sales ledger: The fact or maint ains t he client s’ sales ledgers. On t ransact ing a
sales deal, an invoice is sent t o t he cust omer and a copy of t he same is sent t o t he fact or. The fact or also gives
periodic report s t o t he client .

• Collection facility: The fact or undertakes t o collect t he receivables on behalf of t he client relieving him of t he
problems involved in collect ion, and enables him t o concent rat e on ot her import ant funct ional areas of t he
business. It also enables t he client t o reduce t he cost of collect ion by way of savings in manpow er, t ime and
effort s.

• Financing Trade Debts: The unique feat ure of fact oring is t hat a fact or purchases t he book debt s of it s client s
at a price and t he debt s are assigned in favour of fact or w ho is usually w illing t o grant advances t o t he ext ent of
80% of t he assigned debt s.

• Credit Control and Credit Protection: Assumpt ions of credit risk is one of t he most import ant funct ions of t he
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fact or. This service is provided w here debt s are fact ored w it hout recourse. The fact or in consultat ion w it h t he
client fixes credit limit s for approved cust omers.

• Advisory Services: By virt ue of t heir specialized know ledge and experience in finance and credit dealings and
access t o ext ensive credit informat ion; fact ors can provide t he follow ing
informat ion services t o t he client s:
(i) Cust omer ’s percept ion of t he client ’s product s, changing in market ing st rategies, emerging t rends et c.
(ii) Audit of t he procedures follow ed for invoicing, delivery and dealing w it h sales ret urns.
(iii) Int roduct ion to t he 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:

• Fact oring provides immediat e cash flow in t he form of 80% of t he invoice value w hich helps in building t he
liquidit y posit ion of t he client . Also, t his proport ion of finance is higher t han bank finance against credit sales.
• It also plays an important role in client ’s w orking capital finance.
• The cash realized by receiving advance amount from t he fact or can be usedt o accelerat e t he product ion cycle.
• The client need not have t o spend t ime on sales ledger maint enance, follow up and collect ion of receivables as
t his can be done by fact oring company w ho buys such receivables. This helps in saving t he precious t ime of t he
client as it can concent rate on it s core act ivit ies such as product ion, market ing etc.
• This provides comprehensive credit cont rol syst em w hich helps in assessing t he q ual i t y o f d eb t o r s an d
monit oring t heir financial healt h.
The fact oring process helps in reducing t he average receivables collect ion period. As a result , t he t ot al operat ing
cycle t ime of t he client is also reduced. This w ill ult imat ely leads t o efficient w orking capit al management .

6. FACTORS INHIBITING THE GROW TH OF FACTORING IN INDIA

The fact oring indust ry has grow n up rapidly around t he w orld. M ore t han one lakh businesses are current ly
using fact oring t o sett le t heir t rade t ransact ion. How ever, t he fact oring 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 syst em and aut hent ic client dat a base have rest rict ed t he grow t h model of f act oring
and it s arrangement s.
(ii) Higher st amp dut y w hile assigning t he invoice t o t he fact or w ill increase t he cost of t he client w hich leads t o
reduct ion in fact oring arrangement s.

To remove the above limitations and expand the factoring market in India, the following can be suggested:
(i) Do aw ay w it h st amp dut y or at least reduce it .
(ii) Incorporat e a separat e company w hich w ill give a t rue and fair credit appraisal report and w hich w ill cover all
aspect of client ’s informat ion and t heir account s.
(iii) Fact oring companies should expand t heir net w ork and branches especially t o t hose localit ies w here sm all
scale unit s are locat ed.
(iv) Work shop and seminars should be organized by fact oring companies t o enhance awareness and usefulness
of t he fact oring process.
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7. FORFAITING
Forfait ing is a form of financing of receivables pert aining t o int ernat ional t rade. It denot es t he purchase of
t rade bills/ promissory notes by a bank/ financial inst it ut ion w it hout recourse t o t he seller. The purchase is in t he
form of discounting the documents covering the entire risk of non­payment in collection. All risk and collection
problems are fully t he responsibilit y of t he purchaser (forfait er) w ho pays cash t o t he seller aft er discount ing t he
bills/ not es.

Difference between Forfaiting vs Export Factoring

(a) A forfait er discount s t he ent ire value of t he not e/ bill. In a fact oring arrangem ent t he ext ent of financing
available is 75-80%.
(b) The forfaiter ’s decision t o provide financing depends upon t he financing standing of t he availing bank. On t he
ot her hand in a fact oring deal t he export fact or bases his credit decision on t he credit standards of t he exporter.
(c) Forfait ing is a pure financial agreement w hile fact oring includes ledger administ rat ion as w ell as collect ion.
(d) Fact oring is a short -t erm 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, Regulat ory Aspect s of Fact oring can be referred from Fact oring Regulat ion Act , 2011 and Non-Banking
Financial Company - Fact ors (Reserve Bank) Direct ions, 2012.

9.1Provisions in brief from the Factoring Regulation Act, 2011

(i) No fact or shall commence or carry on t he fact oring business unless it obt ains a cert ificat e of regist rat ion from
t he Reserve Bank t o commence or carry on t he fact oring business under t his Act .
For t he removal of doubt s it is hereby clarified t hat a non-banking financial company engaged in fact oring business
shall be t reat ed as engaged in fact oring business as it s “ principal business” if it fulfils the following conditions,
namely:—
(a) If it s financial asset s in t he fact oring business are more t han fift y per cent . of it s t ot al asset s or such per cent .
as may be st ipulat ed by t he Reserve Bank; and
(b) If it s income from fact oring business is more t han fift y per cent . of t he gross income or such per cent . as may
be st ipulat ed by t he Reserve Bank.
(ii) The Reserve Bank m ay, if it considers necessary in t he interest of business ent erprises availing fact oring
services or in t he interest of fact ors or interest of ot her stake holders give direct ions t o t he fact ors eit her generally
or t o any fact or in part icular or group of fact ors in respect of any mat t ers relat ing t o or connect ed w it h t he
fact oring business undertaken by such fact ors. If any fact or fails t o comply w it h any direct ion given by t he Reserve
Bank, t he Reserve Bank may prohibit such fact or from undert aking t he fact oring business.

The person w ho has t o receive any amount from t he debt ors or w ho is ow ner of any receivable shall, at t he t ime
of ent ering an agreement w it h t he fact or disclose t o t he fact or any defences and right of set off t hat may be
available t o t he debt or. Upon entering t he agreement , any securit y created t o secure t he payment of receivable
shall vest in t he fact or and he is eligible t o exercise all t he right s and remedies w het her by w ay of damages or
ot herw ise w hich w ould ot herw ise available t o t he ow ner of receivable.

Before demanding any payment from t he debt ors, t he fact or shall give a proper not ice t o him. Aft er receiving
t he not ice, t he debt ors shall make t he required payment t o t he fact or and t his w ill fully discharge t he liabilit y of
the debt or.
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In case, no not ice for payment is received by t he debt or, and he makes t he required payment t o t he ow ner of
receivable, such amount shall be paid fort hw it h by him t o t he fact or. So, t he ow ner of t he receivable act s as a
t rustee in t his sit uat ion and he holds t he amount received from t he debt or in t rust for t he fact or.

If any modificat ion in t he original cont ract takes place bet w een t he ow ner of receivable and t he fact or, w ill not
be binding against t he fact or unless he consent s t o it . If t he ow ner of receivable commit s any breach of original
cont ract w it h debt or, t he debt or can claim any loss or damage caused t o him in consequence of t hat .

Every fact or shall for t he purpose of regist rat ion,file t he part iculars of every t ransact ion of assignment of
receivables t o t he Cent ral Regist ry t o be set up under Securit isat ion and Reconst ruct ion of Financial Asset s and
Enforcement of Securit y Interest (SARFAESI) Act , 2002 w it hin 30 days from t he date of such assignment or from
t he date of establishment of such regist ry.

9.2.As per the Non-Banking Financial Company - Factors (Reserve Bank) Directions, 2012
Follow ing addit ional point s may be not ed w it h relat ion t o fact oring in t his regard:
(i) An ent it y not regist ered w it h t he Reserve Bank of India (RBI) may conduct t he business of fact oring if it is an
ent it y ment ioned in Sect ion 5 of t he Act i.e. a bank or any corporat ion est ablished under an Act of Parliament or
St at e Legislat ure, or a Government Company as defined under sect ion 617 of t he Companies Act , 1956.
(ii) Every company seeking regist rat ion as NBFC-Fact or shall have a minimum Net Ow ned Fund (NOF) of ` 5 crore.
Exist ing companies seeking regist rat ion as NBFC-Fact or but do not fulfil t he NOF crit erion of ‘ 5 crore may approach
t he Bank for t ime t o comply w it h t he requirement .
(iii) A new company t hat is grant ed Cert ificat e of Regist rat ion (CoR) by t he RBI as NBFC-Fact or shall comm ence
business w it hin six mont hs from t he dat e of grant of CoR by t he RBI.
(iv) An NBFC-Fact or shall ensure t hat it s financial asset s in t he fact oring business const it ut e at least 50 per cent
of it s t ot al asset s and t he income derived from fact oring business is not less t han 50 per cent of it s gross income.
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FACTORING-PRACTICAL
NET BENEFIT OF FACTORING

QUESTION NO.1 A company is considering t o engage a fact or, t he follow ing informat ion is available
(i) The current average collect ion period for t he Company's debt ors is 80 days and ½% of debt ors default . The
fact or has agreed t o pay money due after 60 days and w ill take t he responsibilit y of any loss on account of bad
debts.
(ii) The annual charge for t he fact oring is 2% of t urnover payable annually. Administ rat ion cost saving is likely t o
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
borrow ing is 15% per annum. Assume t he year is consist ing of 365 days.Should t he Company ent er int o a fact or-
ing agreement ?

EFFECTIVE COST OF INTEREST UNDER FACTORING

QUESTION NO. 2AX Lt d. has a t ot al sales of ` 4 crores and it s average collect ion period is 90 days. The past
experience indicat es t hat bad-debt losses are 1.5% on Sales. The expendit ure incurred by t he firm in administ ering
it s receivable collect ion effort s are ` 6,00,000. A fact or is prepared t o buy t he firm’s receivables by charging 2%
Commission. The fact or w ill pay advance on receivables t o t he firm at an int erest rat e of 18% p.a. aft er w it hholding
10% as reserve ,ot her required commission & interest .Calculat e t he effect ive cost of fact oring t o t he Firm.(Assume
= 360 days)

QUESTION NO.2BM / s At lant ic Company Limit ed w it h a t urnover of ` 4.80 crores is expect ing grow t h of 25% for
fort hcoming year. Average credit period is 90 days. The past experience show s t hat bad debt losses are 1.75% on
sales. The Company’s administering cost for collect ing receivables is ` 6,00,000/ -.It has decided t o take fact oring
service of Pacific Fact ors on t erms t hat fact or w ill buy receivables by charging 2% commission and 20% risk w it h
recourse. The fact or w ill pay advance on receivables t o t he firm at 16% int erest rat e per annum aft er w it hholding
10% as reserve,ot her required commission & int erest .Calculat e t he effect ive cost of factoring t o the firm. (Assume
360 days in a year)
Solution:
18.72 Lakhs
Effect ive Cost of Fact oring : × 100 = ` 14.77%
126.72 Lakhs

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:
Debt ors ` 6.00 crore x 90/360 150.00
Less: 10% w it hholding (15.00)
Less: Commission 2% (3.00)
Amount Of Advance 132.00
Less: Int erest @16% for 90 days on ` 132 lacs 5.28__
Net Advance Amount Received 126.72
Working Note
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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 Debt s (` 600 lacs x 1.75% x 80%) 8.40
Benefit 14.40
Net Cost Paid (A-B) 18.72

QUESTION NO.2CPQR Lt d. has credit sales of ` 165 crores during t he financial year 2014-15 and it s average
collect ion period is 65 days. The past experience suggest s t hat bad debt losses are 4.28% of credit sales.
Administ rat ion cost incurred in collect ion of it s receivables is ` 12,35,000 p. a. A fact or is prepared t o buy t he
company’s receivables by charging 1.95% commission. The fact or w ill pay advance on receivables t o t he company
at an int erest rat e of 16% p.a. aft er w it hholding 15% as reserve,commission & int erest .
Estimate t he effect ive cost of fact oring t o t he company assuming 360 days in a year.
Solution:
- .0095
Effect ive Cost of Fact oring : × 100 = -0.0395%
24.0272
Note :Negat ive sign indicat es benefit due t o fact oring.

Working Note :
Calculation Of Net Amount Of Advance Received :
Particulars ` crore
Debt ors = ` 165 crore x 65 / 360 29.7916
Fact oring commission = ` 29.7916crore x 1.95/100 0.5809
Fact oring reserve = ` 29.7916 crore x 15/100 4.4687
Amount Of Advance 24.742
Fact or w ill deduct his interest @ 16%:-24.742x16/100 x 65/360 .7148
Net Amount Of Advance Received 24.0272
Working Note :
Calculation of Net Cost Paid :
Cost:
Fact oring commission (` 0.5809 crorex 360/ 65) 3.2173
Int erest charges (` 0.7148 crorex 360 / 65) 3.9589
Tot al 7.1760
Benefit:
Cost of credit administ rat ion saved 0.1235
Cost of Bad Debt s (` 165 crorex 4.28 / 100) avoided 7.0620
Tot al 7.1855
Net cost t o t he Firm (` 7.1760 - ` 7.1855) -0.0095

QUESTION NO.2D A Lt d. Has annual credit sales of ` 219 lakh and it s average collect ion period is 50 days. The
past experience indicat es t hat bad debt losses are around 2% of credit sales. The fact oring is expect ed t o save `
2 lakh in administ rat ion cost s and also t o eliminat e all bad debt losses. The fact or has agreed t o advance 80% of
t he receivables at 15% p.a. deduct ing it s fact oring commission and int erest . Compute t he net fact oring cost if
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fact oring commission is 2%.
Solution:
1.504
Effect ive Cost of Fact oring : × 100 = 6.56%
22.92
Working Note :
Calculation Of Net Amount Of Advance Received :
Debt ors = (` 219lakh / 365) X 50 = ` 30 lakh
Amount Of Advance = 80% of ` 30 lakh = ` 24 lakh
Fact oring Commission = 2% on ` 30 lakh = ` 0.6 lakh
= ` 23.4 lakh
Int erest 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 :
Calculation of Net Cost Paid :
Cost:
Fact oring 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 W HEN COM PANY IS DEPENDENT ON OVERDRAFT FACILITY

QUESTION NO.3AThe follow ing financial informat ion related t o N Ltd.:

Sales (all on credit ) ` 37400000
Trade receivables ` 4600000
The average variable overdraft interest rate in each year was 5%. A fact or has offered t o take over t he administ rat ion
of t rade receivables on a nonrecourse basis for an annual fee of 3% of credit sales. The fact or w ill maint ain a
t rade receivables collect ion period of 30 days and N Lt d w ill save ` 1,00,000 per year in administ rat ion cost s and
` 3,50,000 per year in bad debt s. A condit ion of t he fact oring agreement is t hat t he fact or w ould advance 80% of
the face value of receivables at an annual int erest rat e of 7%. Evaluate w het her t he proposal t o fact or t rade
receivables is financially accept able.(For calculat ion, assume one year = 365 days)

QUESTION NO.3BThe credit sales and receivables of DEF Lt d. at t he end of year are est imat ed at ` 561 lakhs and
` 69 lakhs respect ively.
The average variable overdraft int erest rat e is 5% p.a.
DEF Lt d. is considering a fact oring proposal for it s receivables on a non-recourse basis at an annual fee of 1.25%
of credit sales.
As a result , DEF Lt d. w ill save ` 1.5 lakhs p.a. in administ rat ive cost and ` 5.25 lakhs p.a. as bad debt s.
The fact or w ill maint ain a receivables collect ion period of 30 days and w ill 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:Evaluat e t he viabilit y of fact oring proposal.
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Solution:
Calculation Of Net Benefit Due To Factoring
Total Savings (A)
Int erest Earned Due Reduct ion In Debt ors ` 22,89,041 @ 5% 1,14,452
Saving of Administ rat ion cost s 1,50,000
Saving of Bad debt s 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)
Int erest Paid ` 36,88,767 @ 7% 2,58,214
Commission Charges (` 5,61,00,000 @ 1.25%) 7,01,250
Tot al 9,59,464
Net Saving (A) - (B) 14,426
Decision: Since Net Saving is posit ive t he proposal is viable and can be accept ed.
Working Note :Reduct ion In Debt ors
Exist ing Debt ors 69,00,000
30
New Debt ors 561,00 ,000 × 46,10,959
365
Reduct ion in Debt ors(` 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.4 Champak Limit ed is a sm all m anufact uring com pany of sm all t eddy bears for babies and is
suffering cash flow crunch. The company had already ut ilized it s maximum overdraft facilit y. The average sale (at
invoice value) of Champak Limit ed is ` 40,00,000 per mont h, and cust omers are allow ed t o pay in 45 days from
t he date of invoice. The past experience indicates t hat bad-debt losses are 1.5% on sales. To meet t he cash
crunch sit uat ion CFO of t he company has suggest ed follow ing t w o opt ions:
Option 1 (Factoring): Bank X (a fact oring firm) is ready t o provide fact oring services and w ould advance 75% of
t he value of t he invoices, deduct ing commission & int erest @ 10 percent per annum. For t hese fact oring services
Bank X, w ould charge a service fee of 2% of t he t ot al invoice value. It is est imat ed t hat by using t he fact oring
services, Champak Limit ed w ould able t o save administ rat ion cost s of ` 50,000 per mont h.
Option 2 (Offering Discount): Champak Limit ed could also offer a cash discount of 2% discount for payment s
made w it hin 10 days of invoicing.
(i) Calculat e effect ive annualized net cost / cost under t hese t w o opt ions assuming fact oring agreement is on
recourse basis.
(ii) Calculat e effect ive annualized net cost / cost under t hese t w o opt ions assuming fact oring agreement is on non-
recourse basis and X Bank w ould charge services charges @3% inst ead of 2%.
Note : Assume 360 days in a year.
Solution:
(i)(a)EffectiveAnnualized Net Cost under Factoring option (W ith Recourse)
7,98,000
Effect ive Cost of Fact oring : × 100 = 18.45%
43,25,250
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Calculation of Net Cost Paid :

Cost:
Fact oring 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 :
Calculation Of Net Amount Of Advance Received :
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
Fact oring commission = ` 60,00,000 x 2/100 1,20,000
43,80,000
Fact or w ill deduct his int erest @ 10% :
` 43,80,000x10x45/100x360 ` 54,750
Net Amount Of Advance Received 43,25,250
(b)Effective Annualized Cost under Discount option
Since Champak Lt d. is offering a discount of 2% for payment in 10 days t he cust omer w ho opt s for t his opt ion
instead of 45 days are paying 35 days earlier. Accordingly,
98(1 + d) = 100 i.e.d = 2.04 %
By using follow ing formula of simple int erest t he effect ive annual cost of discount opt ion can be found as follow s:
2.04% x 360/35 = 20.98%
(ii)(a)Effective Annualized Net Cost under Factoring option (W ithout Recourse)
5,52,000
Effect ive Cost of Fact oring : × 100 = 12.94%
42,66,000
Working Note :
Calculation of Net Cost Paid :
Cost:
Fact oring commission (` 1,80,000 x 360/45) 14,40,000
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 Debt s (` 4,80,00,000 x 1.5/100) avoided 7,20,000_
Benefit 13,20,000
Net Cost 5,52,000
Working Note:
Calculation Of Net Amount Of Advance Received :
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
Fact oring commission = 60,00,000 x 3/100 1,80,000
43,20,000
Fact or w ill deduct his int erest @ 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 comput ed above)

EPQ(EX T RA PRAT I CAL QU EST I ON S)

QUESTION NO. 1 The credit sales and receivables of M / s M Ltd. at t he end of the year are estimat ed 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 fact oring it s debt s on a non-recourse basis at an annual fee of 3% on credit sales. As a result , M Lt d. w ill save
` 1,00,000 per year in administ rat ive cost and ` 3,50,000 as bad debt s. The fact or w ill maint ain a receivables
collect ion period of 30 days and advance 80% of t he face value t hereof at an annual int erest rat e of 7%. Evaluate
t he viabilit y of t he proposal.
Solution:
Est imat ed Receivables 46,00,000
Est imated Receivables under Fact or (` 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 cost s ` 15,26,027 @ 5% 76,301
Saving of Administ rat ion cost s 1,00,000
Saving of Bad debt s Total 3,50,000
5,26,301
Total Cost of Factoring (B)
Int erest on advances by Fact or
Advances ` 30,73,973 @ 80% 24,59,178
Int erest on ` 24,59,178 @ 7% 1,72,142
Overdraft Int erest Saved on ` 24,59,178 @ 5% (` 1,22,959) 49,183
Chages payable t o Fact or (` 3,74,00,000 @ 3%) 11,22,000
11,71,183
Net Saving (A) - (B) (6,44,882)
Since Net Saving is negat ive t he proposal is not viable and hence should not be accept ed.

QUESTION NO. 2 Ext ract s from t he recent financial statement s of ABC Ltd. are given below.
` ‘000
Turnover 21,300
Cost of sales 16,400
Gross Profit 4,900
Non-current asset s 3,000
Current asset s
Inventory 4,500
Trade receivables 3,500 8,000
Tot al Asset s 11,000
Trade payables 3,000
Overdraft 3,000 6,000
Equit y Shares 1,000
Reserves 1,000 2,000
Debentures 3,000
Total Liabilit ies 11,000
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XYZ Fincorp, a fact or has offered t o m anage t he t rade receivables of ABC Lt d. under a servicing and fact or-
financing agreement . XYZ expect s t o reduce t he average t rade receivables period of ABC from it s current level t o
35 days; t o reduce bad debt s from 0.9% of t urnover t o 0.6% of t urnover; and t o save ABC ` 40,000 per year in
administ rat ion cost s.
The XYZ w ould also make an advance t o ABC of 80% of t he revised book value of t rade receivables. The interest
rat e on t he advance w ould be 2% higher t han t he 7% t hat ABC current ly pays on it s overdraft . The XYZ w ould
charge a fee of 0.75% of t urnover on a w it h-recourse basis. or a fee of 1.25% of t urnover on a non-recourse basis.
Assuming 365 days in a year and all sales and purchases are on credit you are required to evaluate t he 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 fact oring 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 t he XYZ’s offer is w it h recourse, ABC w ill gain t he benefit of bad debt s reducing from 0.9% of t urnover t o 0.6%
of t urnover.
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 int erest on advance(` 2,042.466 x 0.8 x 0.02) 32680
Net benefit before fact or fee (A) 173247
Wit h-recourse fact or fee = ` 21,300,000 x 00075 (B) 159750
Net benefit of w it h-recourse ofer (A) — (B) 13497

Calculation of benefit of non-recourse offer

As t he offer is w it hout recourse, t he bad debt s of ABC w ill reduce t o zero, as t hese w ill be carried by t he XYZ, and
so t he company w ill gain a furt her benefit of 0.6% of t urnover.
Net benefit before w it h-recourse fact or fee (A) as above 173,247
Non-recourse fact or fee ` 21,300,000 x 0.0125 (D) 266,250
Net cost before adjust ing for bad debt s (E) = (D) — (A) 93,003
Remaining bad debt s eliminat ed = ` 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 t he fact or is financially more att ract ive t han t he w it h-recourse ofer.

QUESTION NO. 3 M / s At lant ic Company Limit ed w it h a t urnover of ` 4.80 crores is expect ing grow t h of 25% for
fort hcoming year. Average credit period is 90 days. The past experience show s t hat bad debt losses are 1.75% on
sales. The Company’s administering cost for collect ing receivables is ` 6,00,000/ -.It has decided t o take fact oring
service of Pacific Fact ors on t erms t hat fact or w ill buy receivables by charging 2% commission and 20% risk w it h
recourse. The fact or w ill pay advance on receivables t o t he firm at 16% int erest rat e per annum aft er w it hholding
10% as reserve. Calculate t he effect ive cost of fact oring t o t he 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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Debt ors ` 6.00 crore x 90 / 360 150.00

Less: 10% w it hholding 15.00 135.00
Less: Commission 2% 3.00
Net payment 132.00
Less: Int erest @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 Debt s (` 600 lacs x 1.75% x 80%) 8.40 14.40
18.72
Effect ive Cost of Fact oring : ` 18.72 lacs/ ` 126.72 lacs ×100 = ` 14.77%

QUESTION NO.4 PQR Lt d. has credit sales of ` 165 crores during t he financial year 2014-15 and it s average
collect ion period is 65 days. The past experience suggest s t hat bad debt losses are 4.28% of credit sales.
Administ rat ion cost incurred in collect ion of it s receivables is ` 12,35,000 p. a. A fact or is prepared t o buy t he
company’s receivables by charging 1.95% commission. The fact or w ill pay advance on receivables t o t he company
at an int erest rat e of 16% p.a. aft er w it hholding 15% as reserve,commission & int erest .
Est imate t he effect ive cost of fact oring t o t he company assuming 360 days in a year.
Solution:
Particulars ` crore
Average level of Receivables = ` 165 crore x 65/360 29.7916
Fact oring commission = ` 29.7916crore x 1.95/100 0.5809
Fact oring reserve = ` 29.7916crore x 15/100 4.4687
Amount available for advance = ` 29.7916 — (0.5809 + 4.4687) 24.742
Fact or w ill deduct his int erest @ 16%:-
` 24.742x16/100 x 65/360 0.7148
Advance t o be paid = (` 24.742— ` 0.7148) 24.0272
Annual Cost of Factoring to the Firm p.a :
Fact oring commission (` 0.5809 crore x 360/65) 3.2173
Interest charges (` 0.7148 crore x 360/65) 3.9589
Tot al 7.1760
Firm’s Savings on taking Factoring Service p.a:
Cost of credit administ rat ion saved 0.1235
Cost of Bad Debt s (` 165 crore x 4.28/100) avoided 7.0620
Tot al 7.1855
Net cost t o t he Firm (` 7.1760 - ` 7.1855) -0.0095

Effect ive cost of fact oring t o t he firm - -0.0395%

-0.0095/24.0272 x 100
Note :Negat ive sign indicat es benefit due t o fact oring.

QUESTION NO.5 A Lt d. Has annual credit sales of ` 219 lakh and it s average collect ion period is 50 days. The past
experience indicat es t hat bad debt losses are around 2% of credit sales. The fact oring is expect ed t o save ` 2
lakh in administ rat ion cost s and also t o eliminat e all bad debt losses. The fact or has agreed t o advance 80% of
t he receivables at 15% p.a. aft er deduct ing it s fact oring commission and int erest . Compute t he net fact oring cost
if fact oring commission is 2%.
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Solution:
Average receivable = (` 219lakh/365) X 50 = ` 30 lakh
Fact oring Commission = 2% on ` 30 lakh = ` 0.6 lakh
Amount available for advance = 80% of ` 30 lakh – Fact oring 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 t ed t o client = ` 23.4 lakh – ` 0.48 lakh= ` 22.92 lakh
Fact oring cost for 50 days = Fact oring commission + Int erest
= ` 0.6 lakh + ` 0.48 lakh = ` 1.08 lakh
Fact oring cost for year = (` 1.08 lakh) x (365/50) = ` 7.884 lakh
Net Fact oring Cost
Particulars ` lakh
Fact oring cost per year 7.884
Less: Cost s saved per year
Bad Debt = 2% on ` 219 lakh 4.38
Administ rat ion cost saved 2.00 6.380
Net Fact oring cost per year 1.504
Advance 22.920
Net Fact oring cost per year (in %) = (1.504/22.92) X 100 6.56%

QUESTION NO.6 Beanst alk Lt d. manages it s account s receivable int ernally by it s sales and credit depart ment .
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 t he company has been t hat on an average 40 percent of t he cust omers avail of t he
discount by paying w it hin 10 days w hile t he balance of t he receivables are collect ed on average 90 days aft er t he
invoice dat e. Bad debt s of t he company are current ly 1.5 percent of t ot al sales. The project ed sales for t he next
year are ` 1,000 crores.
Beanst alk Lt d. finances it s invest ment in debt ors t hrough a mix of bank credit and ow n long t erm funds in t he
rat io of 70:30. The current cost of bank credit and long term funds are 13 percent and 15 percent respect ively.
Wit h escalat ing cost associat ed w it h t he in house management of debt ors coupled wit h t he need t o unburden t he
managem ent w it h t he t ask so as t o focus on sales promot ion, t he Company is examining t he possibilit y of
out sourcing it s fact oring service for managing it s receivable and has t w o proposals on hand w it h a guarant eed
payment w it hin 30 days.
The main element s of t he Proposal I from Finebank Factors Ltd . are:
• Advance, 88 percent and 84 percent for t he recourse and non recourse arrangement s.
• Discount (Int erest ) charge in advance, 21 percent for w it h recourse and 22 percent w it hout recourse.
• Commission, 4.5 percent w it hout recourse and 2.5 percent w it h recourse.
The main element s of t he Proposal II from Roughbank Factors Ltd. are:
• Advance, 84 percent w it h recourse and 80 percent w it hout recourse respect ively.
• Discount (Int erest )charge upfront w it hout recourse 21 percent and w it h recourse 20 percent .
• Commission upfront , w it hout recourse 3.6 percent and w it h recourse 1.8 percent .
The opinion of t he Chief M arket ing M anager is t hat in t he context of t he fact oring arrangement , his staff w ould
be able exclusively focus on sales promot ion w hich w ould result in addit ional sales of 10% of project ed sales.
Kindly advice as a financial consultant on t he alternat ive proposals. What advice w ould 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 Invest ment in Receivable* 21.61

54.61
* Cost of Invest ment in Receivable
Average Collect ion Period (0.40 x 10 days + 0.60 x 90 days) 58 days
Invest ment in Debt ors (` 1000 crores x 58/365) ` 158.90 crores
Cost of Invest ment (0.70 x 13 + 0.30 x 15) 13.60%
Cost of Invest ment in Receivable (` 158.90 crores x 13.60%) ` 21.61 crores
(B) Finebank Proposal W ith Recourse W ithout 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 Debt or is ` 1100 crore.This fund blockage is
reduced by advance given by fact or w hich is ` 943.80 crore (` 1100 crores – ` 27.50 crores) in first case.How ever
amount of fund st ill blocked in debt or is ` 156.2 crore(` 1100 crores – ` 943.80 crores) for w hich company w ill
have t o bear cost at t he rat e of 15% assuming it t o funded from ow n long t erm funds.
(C) Roughbank Proposal W ith Recourse W ithout Recourse
Factoring Commission
(` 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: W ith Recourse
Fine bank Rough bank
Benefit s (` 54.61 crore – ` 15 crore) 39.61 39.61
Cost s 45.72 37.09
Bad Debt s (6.11) 2.52
Decision Analysis: W ithout Recourse
Fine bank Rough bank
Benefit s 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 accept ed.

QUESTION NO.7 A Lt d. has an export sale of ` 50 crore of w hich 20% is paid by import ers in advance of dispat ch
and for balance t he average collect ion period is 60 days. How ever, it has been observed t hat t hese payment s
have been running lat e by 18 days. The past experience indicat es t hat bad debt losses are 0.6% on Sales. The
expendit ure incurred for effort s in receivable collect ion are ` 60,00,000 p.a.
So far A Lt d. had no specific arrangement s t o deal w it h export receivables, follow ing t w o proposals are under
considerat ion:
(i) A non-recourse export fact oring agency is ready t o buy A Ltd.’s receivables by charging 2% commission. The
fact or w ill pay an advance on receivables t o t he firm at an int erest rat e of M IBOR + 1.75% aft er w it hholding 20%
as reserve.
(ii) Insu Lt d. an insurance company has offered a comprehensive insurance policy at a premium of 0.45% of t he
sum insured covering 85% of risk of non-payment . A Lt d. can assign it s right t o a bank in ret urn of an advance of
75% of t he value insured at M IBOR+1.50%.
Assuming t hat M IBOR is 6% and A Lt d. can borrow from it s bank at M IBOR+2% by using exist ing overdraft facilit y
determine w hich of t he t w o 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 Debt s 0.6% x ` 40 crore ` 0.24 crore
Average Export Debt ors
` 40 crore x 78 / 360 ` 8.67 crore
Proposal I - Factoring Services
[Tutorial Note:Non-Recourse means in t he event of default t he loss is borne by t he fact or.i.e if t here are bad
debt s, it w ill be borne by t he fact or.]
Due t o non-recourse fact oring agreement t here w ill be saving of bad debt . A Lt d. can choose one opt ion out of
t hese opt ions:
(a) Using Fact oring Services (Debt Collect ion) only.
(b) Using Fact oring and Finance Services i.e. above services in combinat ion of cash advance.
Since, cash advance rate is low er by 0.25% (2.00% - 1.75%), A Ltd. should take advantage of t he same.
Particulars Amount ( ` )
Annual Fact oring Commission (2% x ` 40 crore) (0.80 crore)
Saving of Administ rat ive Cost 0.60 crore
Saving of Bad Debt s 0.24 crore
Int erest Saving on 80% of Debt ors
(` 8.67 crore x 80% * x 0.25% p.a) 0.01734 crore
Net Saving t o A Lt d. 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 Debt s (85% x ` 0.24 crore) 0.204 crore
Int erest Saving on 75% of Debt ors (0.5% x 75% x ` 8.67 crore) 0.03251 crore
Net Saving t o A Lt d. 0.05651 crore
Decision: Since saving in Fact oring is marginally higher it should be accept ed i.e w e should accept Proposal No.1.
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QUESTION NO.8 Projected sales for t he next year of Z Ltd. is ` 1000 Cr. The com pany m anages it s account s
receivables internally. It s present annual cost of sales ledger administ rat ion is ` 11 Cr. The company finances it s
invest ment on debt ors t hrough a mix of bank credit and ow n long t erm funds in t he rat io of 60: 40.Current cost of
bank credit and long term funds are 10% and 12% respect ively. The past experience indicates t hat bad debt
losses are 1.5% on t ot al sales.
The company has a credit policy of 2/10, net 30.On an average, 40% of receivables are collect ed w it hin t he
discount period and rest are collect ed 70 days aft er t he invoice dat e. Over t he years, gross profit is maint ained at
20% and t he same is expect ed t o be cont inued in fut ure.
To enable t he management focus on promot ional act ivit ies and get rid of escalat ing cost associat ed w it h in
house management of debt ors, t he company is considering t he possibilit y of availing t he services of Fairgrow t h
Fact ors Ltd. for managing receivables of t he company.
According to t he proposal of the factor, it would pay advance t o the t une of 85% of receivables deduct ing commission
w it h 20% int erest and 81% of receivables w it h 21% int erest for t he recourse and non-recourse agreement s
respect ively. The proposal provides for guaranteed payment w it hin 30 days from t he date of invoice. The fact oring
commission w ould be 4% w it hout recourse and 2% w it h recourse.
If t he company goes for t he fact oring arrangement , t he st aff w ould be under burdened and concent rat e more on
promot ional act ivit ies and consequent ly addit ional sales of ` 100 Cr. w ould be achieved. Assume t hat all sales of
t he company are credit sales and t he year is of 360 days. You are required to:
(i) Calculat e cost of in house management of receivables,
(ii) Comput e cost of Fair grow t h Fact ors Lt d. proposal(w it h recourse and w it hout recourse),
(iii) Calculat e net benefit s under recourse fact oring and non-recourse fact oring; and
(iv) Decide t he best opt ion for t he 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 Invest ment in Receivable* 11.04
63.54
* Cost of Invest ment in Receivable
Average Collect ion Period (0.40 x 10 + 0.60 x 70) 46 days
Invest ment in Debt ors (` 1000 crores x 46/360) x 0.80* * ` 102.22 crores
Cost of Invest ment (0.60 x 10 +0.40 x 12) 10.80%
Cost of Invest ment in Receivable (` 102.22 crores x 10.80%) ` 11.04 crores
* * 20% balance is gross profit margin.
(ii) Fairgrowth Factors Ltd. Proposal
W it h W ithout
Recourse Recourse
Fact oring Commission
(` 1100 crores x 2.0% and 1100 crores x 4.0%) 22.00 44.00
Int erest 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 Debt ors
(` 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 Debt or is ` 1100 crore.This fund blockage is
reduced by advance given by fact or w hich is ` 916.30 crore (` 1100 crores – ` 22 crores)x.85 in first case.How ever
amount of fund st ill blocked in debt or is ` 183.7 crore(` 1100 crores – ` 916.3 crores) for w hich company w ill have
t o bear cost at t he rat e of 12% assuming it t o funded from ow n long t erm funds.
(iii) Decision Analysis:
W it h W ithout
Recourse Recourse
Benefit s ( ` 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 fact oring.

QUESTION NO.9 A Lt d. has a t ot al sales of ` 3.2 crores and it s average collect ion period is 90 days. The past
experience indicat es t hat bad-debt losses are 1.5% on Sales. The expendit ure incurred by t he firm in administ ering
it s receivable collect ion effort s are ` 5,00,000. A fact or is prepared t o buy t he firm’s receivables by charging 2%
Commission. The fact or w ill pay advance on receivables t o t he firm at an int erest rat e of 18% p.a. aft er w it hholding
10% as reserve.Calculate t he effect ive cost of fact oring t o t he Firm.
Solution:
Average level of Receivables = 3,20,00,000 x 90/360 80,00,000
Fact oring commission = 80,00,000 x 2/100 1,60,000
Fact oring 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%:­
70 ,40 ,000  18  90
=` 3,16,800
100  360
Advance t o be paid = ` 70,40,000 - ` 3,16,800 = ` 67,23,200
Annual Cost of Factoring to the Firm:
Fact oring commission (` 1,60,000 x 360/90) 6,40,000
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 Debt s (` 3,20,00,000 x 1.5/100) avoided 4.80.000
Tot al 9,80,000
Net cost t o t he Firm (` 19,07,200 - ` 9,80,000) 9,27,200
9 ,27,200 × 100
Effect ive rate of interest t o t he firm = 13.79%
67,23,200
Note: The number of days in a year has been assumed t o be 360 days.
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FACTORING-MCQ
1. Fact oring services w ill provide freedom from:-
(a) hassles of collect ing receivable (b) hassles of paying payables
(c) hassles of selling t he product s/ services (d) hassles of procuring raw mat erials.

2. Fact oring is a kind of __________ service in w hich a business organizat ion ________
(a) management , sells it s Account Recievable (b) financial, sells it s Account s Payable
(c) management , buys it s Account s Payable (d) financial, sells it s Account Receivable

3. Fact oring and Bill discount ing are same?

(a) False (b) True

4. " Fact oring" means an arrangement bet w een a fact or and his client w hich includes t he services t o be provided
by t he fact or. Which of t he follow ing services are not provided?
(a) Finance (b) M aint enance of debt (c) Payment t o credit ors (d) Prot ect ion against
credit risk

5. " Fact oring" means an arrangement bet w een a fact or and his client w hich includes at least _____ of t he
follow ing services t o be provided by t he fact or:
. Finance . M aint enance of debt
. collect ion of debt s . Prot ect ion against credit risk" .
(a) one (b) t w o (c) t hree (d) all

6 . " Fact oring means an arrangement bet w een a fact or and his client w hich includes at least t w o of t he follow ing
services t o be provided by t he fact or:
. Finance . M aint enance of debt .
. Collect ion of debt s . Prot ect ion against credit risk
How ever, t he above definit ion applies only t o fact oring in relat ion t o supply of goods and services:, w hich of t he
follow ing is incorrect s
(a) across nat ional boundaries; (b) t o t rade or professional debt ors;
(c) w hen not ice of assignment has been given t o t he debt or (d) t o t he government

7. In a fact oring t ransact ion, t here are _______ part ies namelt y ,__________
(a) t w o, t he fact or and t he client (b) t hree, t he fact or, t he client and t he cust omers of t he client
(c) t w o, client and t he government (d) t hree, t he fact or, t he t rader and t he cust omer of t he client

8. The fact or,makes prepayment up t o ____ per cent of t he invoice value t o t he client .
(a) 50% (b) 75% (c) 80% (d) 90%

9. The t w o fact oring charges levied are :

(a) service fee and finanace charges (b) service fee and annual maint ainance charges
(c) finance charge and annual maint ainance charges (d) processing fee anf service fee

10. In case of Recourse fact oring, t he loss arising out of irrecoverable receivables is borne by t he:
(a) Fact or (b) client (c) no one (d) bot h (a) and (b)
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11. In case of Non - Recourse fact oring, t he loss arising out of irrecoverable receivables is borne by t he:
(a) Fact or (b) client (c) no one (d) bot h (a) and (b)

12. In advance fact oring, t he fact or paid a pre specified port ion, ranging bet w een __________, of t he fact ored
receivables in advance, t he balance being paid upon collect ion/ on t he guarant eed payment dat e
(a) t hree-fourt hs t o nine t ent hs (b) four-fift h t o nine t ent h
(c) t hree-fourt h t o seven t ent h (d) four-fift h t o seven t ent h

13. Form of fact oring t hat cont ains feat ures of all fact oring services, specially non-resource and advance fact or-
ing is:
(a) Disclosed fact oring (b) full fact oring
(c) Domest ic Fact oring (d) Ult imat e dact oring

14. The name of t he fact or is disclosed in:

(a) Disclosed fact oring. (b) Undisclosed faact oring
(c) Domest ic fact oring (d) full fact oring

15. There are usually ___ part ies involved in a cross border fact oring t ransact ion.
(a) three (b) four (c) five (d)two

16. Which of t he part ies are not involved in cross border fact oring t ransact ionss
(a) Export er (b) Importer (c) Government (d) Import Fact or

17. Which of t he follow ing is also know n as t w o-fact or syst em

(a) Disclosed fact oring. (b) Export / cross border fact oring
(c) Domest ic fact oring (d) full fact oring

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

(a) M aint enance/ administ rat ion of sales ledger (b) Collect ion facilit y
(c) Credit Cont rol and Credit Prot ect ion (d) All of t he above

19. Under Advisory services, w hich of t he follow ing services are provided?
(a) Cust omer's percept ion of t he client 's product s, changing in market ing st rategies, emerging t rends etc.
(b) Audit of t he procedures follow ed for invoicing, delivery and dealing w it h sales ret urns.
(c) Int roduct ion t o t he credit depart ment of bank/ subsidiaries of banks engaged in leasing, hire-purchase, mer-
chant banking.
(d) All of t he above

20. Credit Cont rol and Credit Prot ect ion service is provided w here debt s are fact ored:-
(a) w it hout recourse (b) w it h recourse
(c) part ially w it h recourse (d) none of t he above.

21. Fact ors inhibit ing t he grow t h of fact oring in India are:
(a) Lack of credit appriasaal syst em (b) Lack of aut hent ic client dat abase.
(c) High st amp dut y (d) All of t he above

22 .__________ is a form of financing of receivables pert aining t o int ernat ional t rade. It denot es t he purchase of
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t rade bills/ promissory notes by a bank/ financial inst it ut ion w it hout recourse t o t he seller.
(a) Forfait ing (b) fact oring (c) Export fact oring (d) full fact oring

23. In forfait ing, all risk and collect ion problems are fully t he responsibilit y of t he ______.
(a) purchaser (b) client (c) fact or (d) debt or

24. An NBFC-Fact or shall ensure t hat it s financial asset s in t he fact oring business const it ut e at least ___ per cent
of it s t ot al asset s and t he income derived from fact oring business is not less t han ___ per cent of it s gross
income.
(a) 50, 50 (b) 60, 50 (c) 50, 60 (d) 80, 60

25. A new company t hat is grant ed Cert ificat e of Regist rat ion (CoR) by t he RBI as NBFC-Fact or shall com mence
business w it hin ___ mont hs from t he dat e of grant of CoR by t he RBI.
(a) six (b) seven (c) four (d) nine

26 . Every company seeking regist rat ion as NBFC-Fact or shall have a minimum Net Ow ned Fund (NOF) of:
(a) Rs. 5 crore (b) Rs. 15 crore (c) Rs. 2.5 crore (d) Rs. 25 crore

27. An ent it y not regist ered w it h t he Reserve Bank of India (RBI) may conduct t he business of fact oring if it is an
ent it y ment ioned in t he 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 fact oring business shall be t reat ed as engaged in fact oring
business as it s " principal buesinss" if it fulfils w hich of t he follow ing condit ions?
(a) If it s financial asset s in t he fact oring business are more t han fift y per cent . of it s t ot al asset s or such per cent .
as may be st ipulat ed by t he Reserve Bank; and
(b) If it s income from fact oring business is more t han fift y per cent . of t he gross income or such per cent . as may
be st ipulat ed by t he Reserve Bank.
(c) Bot h (a) and (b)
(d) none of t he above

29. Every fact or shall for t he purpose of regist rat ion, file t he part iculars of every t ransact ion of assignment of
receivables t o t he Cent ral Regist ry t o be set up under Securit isat ion and Reconst ruct ion of Financial Asset s and
Enforcement of Securit y Interest (SARFAESI) Act , 2002 w it hin ____ from t he date of such assignment or from t he
date of establishment of such regist ry.
(a) 30 days (b) 2 mont hs (c) 3 mont hs (d) 1 year

30. To remove t he limitat ions and expand t he fact oring market in India, w hich of t he follow ing can be suggested?
(a) Work shop and seminars should be organized by fact oring companies t o enhance awareness and usefulness
of t he fact oring process.
(b) Incorporat e a separat e company w hich w ill give a t rue and fair credit appraisal report and w hich w ill cover all
aspect of client 's informat ion and t heir account s.
(c) Fact oring companies should expand t heir net w ork and branches especially t o t hose localit ies w here small
scale unit s are locat ed.
(d) All of t he above

ANSW ERS
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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LEASING-THEORY
1.1W hat is lease?
Lease can be defined as a right t o use equipment or capit al goods on payment of periodical amount . This may
broadly be equat ed t o an inst alment credit being ext ended t o t he person using t he asset by t he ow ner of capit al
goods w it h small variat ion.

1.2 Parties to a Lease Agreement

There are t w o principal part ies t o any lease t ransact ion as under:
Lessor : Who is act ual ow ner of equipment permit t ing use t o t he ot her part y on payment of periodical amount .
Lessee : Who acquires t he right t o use t he equipment on payment of periodical amount .

1.3Lease vis-a-vis Hire Purchase

Hire-purchase t ransact ion is also almost similar t o a lease t ransact ion w it h t he basic difference t hat t he person
using t he asset on hire-purchase basis is t he ow ner of t he asset and full t it le is t ransferred t o him aft er he has
paid t he agreed inst allment s. The asset w ill be show n in his balance sheet and he can claim depreciat ion and
ot her allowances on the asset for computat ion of tax during the currency of hire-purchase agreement and thereafter.
In a lease t ransact ion, how ever, t he ow nership of t he equipment always vest s w it h t he lessor and lessee only
get s t he right t o use t he asset . Depreciat ion and ot her allow ances on t he asset w ill be claimed by t he lessor and
t he asset w ill also be show n in t he balance sheet of t he lessor. The lease money paid by t he lessee can be
charged t o his Profit and Loss Account . How ever, t he asset as such w ill not appear in t he balance sheet of t he
lessee. Such asset for t he lessee is, t herefore, called off t he balance sheet asset .

2. TYPES OF LEASING
A lease t ransact ion has many variant s relat ing t o t he t ype and nat ure of leased equipment , am ort isat ion
period, residual value of equipment , period of leasing, opt ion for term inat ion of lease etc. Various t ypes of
leasing t ransact ions are, t herefore, operat ing in t he market on t he basis of t hese variant s. The dif ferent leasing
opt ions may how ever, be grouped in follow ing categories as under:
(a)Operating Lease: In t his t ype of lease t ransact ion, t he primary lease period is short and t he lessor w ould not
be able t o realize t he full cost of t he equipment and ot her incident al charges t hereon during t he init ial lease
period. Besides t he cost of machinery, t he lessor also bears insurance, maintenance and repair cost s etc. The
lessee acquires t he right t o use t he asset for a short durat ion. Agreement s of operat ing lease generally provide
for an opt ion t o t he lessee/ lessor t o t erminat e t he lease aft er due not ice. These agreement s may generally be
preferred by t he lessee in t hefollow ing circumst ances:
• When t he long-t erm suit abilit y of asset is uncert ain.
• When t he asset is subject t o rapid obsolescence.
• When t he asset is required for immediat e use t o t ide over a t emporary problem.
Computers and ot her office equipment s are t he very common assets which form subject mat ter of many operat ing
lease agreement s.

(b)Financial Lease: As against t he t emporary nat ure of an operat ing lease agreement , financial lease agreement
is a long-t erm arrangement , w hich is irrevocable during t he prim ary lease period w hich is generally t he full
economic life of t he leased asset . Under t his arrangement lessor is assured t o realize t he cost of purchasing t he
leased asset , cost of financing it and ot her administ rat ive expenses as w ell as his profit by w ay of lease rent
during t he init ial (primary) periodof leasing itself. Financial lease involves t ransferring almost all t he risks incidental
t o ow nership and benefit s arising t herefrom except t he legal t it le to t he lessee against his irrevocable undert aking
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t o make uncondit ional payment s t o t he lessor as per agreed schedule. This is a closed end arrangement w it h no
opt ion t o lessee t o terminate t he lease agreement subsequent ly. In such lease, t he lessee has t o bear insurance,
maint enance and ot her relat ed cost s. The choice of asset and it s supplier is generally left t o t he lessee in such
t ransact ions. The variant s under financial lease are as under:
• Lease w it h purchase opt ion-w here t he lessee has t he right t o purchase t he leased asset s aft er t he expiry of
init ial lease period at an agreed price.
• Lease w it h lessee having residual benefit s-w here t he lessee has t he right t o share t he sale proceeds of t he
asset aft er expiry of init ial lease period and/ or t o renew t he lease agreement at a low er rent al.
In a few cases of financial lease, t he lessor may not be a single individual but a group of equit y part icipant s and
t he group borrow s a large amount from financial inst it ut ions t o purchase t he leased asset . Such t ransact ion is
called ‘Leveraged lease’.

(c)Sales and Lease Back Leasing: Under t his arrangement an asset w hich already exist s and is used by t he lessee
is first sold t o t he lessor for considerat ion in cash. The same asset is t hen acquired for use under financial lease
agreement from t he lessor. This is a met hod of raising funds immediately required by lessee for w orking capital
or ot her purposes. The lessee cont inues t o make economic use of asset s against payment of lease rent als w hile
ow nership vest s w it h t he lessor.

(d)Sales-Aid-Lease: When t he leasing company (lessor) enters int o an arrangement w it h t he seller, usually
manufact urer of equipment , t o market t he latter ’s product t hrough it s ow n leasing operat ions, it is called a ‘sales-
aid-lease’. The leasing company usually get s a commission on such sales from t he manufact urers and increases
its profit .Apart from t erm loan and ot her facilit ies available from financial inst it utions including banks t o a promoter
t o acquire equipment and ot her capit al goods, t he promot er now has an alt ernat ive opt ion t o acquire economic
use of capit al asset s t hrough leasing. The ult imat e decision t o eit her approach a financial inst it ut ion or a leasing
company w ill, how ever, depend on t he nat ure of each such t ransact ion.

3. ADVANTAGES
• The first and foremost advantage of a lease agreement is it s flexibilit y. The leasing company in most of t he
cases would be prepared to modify t he arrangement t o suit t he specific requirement s of t he lessee. The ownership
of t he leased equipment gives t hem added confidence t o enable t hem t o be more accommodat ive t han t he banks
and ot her financial inst it ut ions.
• The leasing company may finance 100% cost of t he equipment w it hout insist ing for any init ial disbursement by
t he lessee, w hereas 100% finance is generally never allow ed by banks/ financial inst it ut ions.
• Banks/ financial inst it ut ions may involve lengt hy appraisal and impose st ringent t erms and condit ions t o t he
sanct ioned loan. The process is t im e consuming. In cont rast leasing companies may arrange for im mediat e
purchase of equipment on mut ually agreeable t erms.
• Lengt hy and t ime consuming document at ion procedure is involved for t erm loans by banks/ inst it ut ions. The
lease agreement is very simple in comparison.
• In short -t erm lease (operat ing lease) t he lessee is safeguarded against t he risk of obsolescence. It is also an
ideal met hod t o acquire use of an asset required for a t emporary period.
• The use of leased asset s does not affect t he borrow ing capacit y of t he lessee as lease payment may not require
normal lines of credit and are payable from income during t he operat ing period. This neit her affect s t he debt
equit y rat io or t he current rat io of t he lessee.
• Leased equipment is an ‘off t he balance sheet ’ asset being economically used by t he lessee and does not affect
t he debt posit ion of lessee.
• By employing ‘sale and lease back’ arrangement , t he lessee may overcome a financial crisis by immediat ely
arranging cash resources for some emergent applicat ion or for w orking capit al.
• Piecemeal financing of small equipm ent s is convenient ly possible t hrough lease arrangement only as d eb
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• Tax benefit s may also somet imes accrue t o t he lessee depending upon taxGroup Link
stat us.
4.DISADVANTAGES
• t he lease rent als become payable soon aft er t he acquisit ion of asset s and no morat orium period is permissible
as in case of term loans from financial inst it ut ions. The lease arrangement may, t herefore, not be suitable for
set t ing up of t he new project s as it w ould ent ail cash out flow s even before t he project comes int o operat ion.
• The leased asset s are purchased by t he lessor w ho is t he ow ner of equipment . The seller ’s warrant ies for
sat isfact ory operat ion of t he leased asset s may somet imes not be available t o lessee.
• Lessor generally obt ain credit facilit ies from banks et c. t o purchase t he leased equipment w hich are subject t o
hypot hecat ion charge in favour of t he bank. Default in payment by t he lessor may somet imes result in seizure of
asset s by banks causing loss t o t he lessee.
• Lease financing has a very high cost of int erest as compared t o int erest charged on t erm
loans by financial inst it ut ions/ banks.Despit e all t hese disadvant ages, t he flexibilit y and sim plicit y offered by
lease finance is bound t o make it popular. Lease operat ions w ill find increasing use in t he near fut ure.

5. EVALUATION OF LEASE
The most important part in lease financing is it s evaluat ion bot h from t he point of view of Lessee and Lessor.

5.1From Lessee’s Perspective

A lease can be evaluat ed eit her as an invest ment decision or as a financing means. If an invest ment decision
has already been made, a firm (lessee) has t o evaluat e w het her it w ill purchase t he 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 t o borrow ing. The lease evaluat ion t hus is debt financing versus lease financing.
There are t hree met hods of evaluat ing a leasing proposal viz. Present Value analysis, Internal Rate of Ret urn
analysis, and t he Bow er Herringer Williamson met hod.

5.1.1Present Value Analysis (Net Advantage of Leasing)

In t his met hod, t he present value of t he annual lease payment s (t ax adjust ed) is compared w it h t hat of t he
annual loan repayment s adjust ed for t ax shield on depreciat ion and int erest , and t he alt ernat ive w hich has t he
lesser cash out flow w ill be chosen.
Ot herw ise w e can also define it as Net Advant age of Leasing (NAL) as follow s:
NAL = PV of Cost of Ow ning - PV of Leasing
If NAL is posit ive, w e should opt for leasing ot herw ise borrow ing and buying opt ion.

5.1.2 Internal rate of return analysis

Under t his met hod t here is no need t o assume any rate of discount . To t his extent , t his is different from t he
former met hod w here t he aft er-t ax cost of borrow ed capit al w as used as t he rat e of discount . The result of t his
analysis is t he aft er-t ax cost of capit al explicit in t he lease w hich can be compared w it h t hat of t he ot her available
sources of finance such as a fresh issue of equit y capit al, ret ained earnings or debt . Simply st at ed, t his met hod
seeks t o est ablish t he rat e at w hich t he lease rent als, net of t ax shield on depreciat ion are equal t o t he cost of
leasing.

5.1.3 Bower-Herringer-W illiamson M ethod

This met hod segregat es t he financial and t ax aspect s of lease financing. If t he operat ing advant age of a lease
is more t han it s financial disadvant age or vice-versa lease w ill be preferred.
The procedure of evaluat ion is briefly as follow s:
1. Compare t he present value of debt w it h t he discount ed valueof lease payment s(gross),t he r at e of discount
being t he gross cost of debt capit al. The net present value is t he financial advant age (or disadvant age).
2. Work out t he comparat ive tax benefit during t heperiodanddiscount it at an appropriat e
cost of capit al. The present value is t he operat ing advant age (or disadvant age) of leasing.
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3. If t he net result is an advant age, select leasing.

5.1.4 Selection of Discount Rate

While examining t he proposals of Lease Vs. Borrow ing and Buying t he select ion of discount ing rate for discount ing
is an issue. Related cash flow s can be discounted bot h at t he rate of Post Tax Cost of Debt and Cost of Capital and
final decision w ill be same. How ever, since leasing is subst it ute for borrow ing 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 Capit al Budget ing Decision involving financing of
asset out of t he funds acquired from various sources involving some cost s.
Accordingly, Lessor w ould like t o invest only if it has posit ive ret urn. In ot her w ords, t he Lessor w ould be ready for
t he financing proposal if t he ret urn from it is more t han cost of funds involved.
Like t radit ional capital budget ing decision, t he Lessor can accept t he proposal of financing on t he follow ing
met hods of evaluat ion:

(i)Net Present Value (NPV) M ethod: The Lessor w ould accept t he proposal of financing t he asset if NPV of t he
same is zero or more. If it is negat ive, t hen it w ould not be accept ed as it w ould not be beneficial t o accept t he
proposal.

(ii)Internal Rate of Return (IRR) M ethod: In t erms of IRR M et hod t he financing proposal should be accept ed
only if computed IRR of cash flow s is more t han t he required cut-off rate or Cost of Capital or Weighted Average
Cost of Capital (WACC).
Like Capital Budget ing Decision t he various t ypes of Cash flow s involved in financing decisions are as follow s:

(a)Initial Cash Outflow: Like in Capital Budget ing decision, t he init ial cash out flow in financing proposal involves
t he Purchase Price of M achine and incident al expenses t heret o.

(b)Annual Cash Flows: The Annual Cash Flow shall be accrued in t he form of Annual Lease Rent al adjust ed in
light of tax benefit s on Depreciat ion and tax liabilit y. Accordingly, it can be computed as follow s:
= (Lease Rent al - Depreciat ion) X (1 - t ) + Depreciat ion

(c)Terminal Cash Flows: Just like in t he terminal year of a project in financing proposal, t he terminal cash flow
involved is disposal/ salvage value of t he asset financed net of Tax Adjust ment on Short Term Capital Loss or
Gain, if any.
In case of NPV met hod, t he above ment ioned cash flow s are discount ed at Cost of Capit al and in IRR M et hod, t he
Cut Off rate is computed from t hese Cash Flow s and compared w it h Cost of Capital or WACC.

6. BREAK EVEN LEASE RENTAL (BELR)

Break-Even Lease Rental can be view ed bot h from t he perspect ive of lessee as w ell as t he lessor.

6.1 Break Even Lease Rental (BELR) from Lessee’s point of view
From t he point of view of lessee, t he BELR is t he rent al at w hich t he lessee is indifferent bet w een borrow ing
and buying opt ion and lease financing opt ion. In ot her w ords, he can opt for any one opt ion. At t his rent al t he Net
Advant age of Leasing (NAL) w ill be zero. It can also be defined as maximum lease rent al t he lessee w ould be
w illing t o pay.
In case if BELR is less t han t he act ual lease rent payable, t he lease opt ion w ould not be viable.
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6.2 Break Even Lease Rental (BELR) from Lessor’s point of V iew
From t he lessor ’s view point , BELR is t he minimum (floor) lease rental, w hich he should accept . In t his case also
NAL should be zero. Any lease rent below BELR should not be accept ed. It is t o be not ed t hat w hile comput ing
NAL, t he over all cost of capit al of t he firm should be used.

7. CROSS-BORDER LEASING
Cross-border leasing can be considered as an alternat ive t o equipment loans in some emerging foreign market ,
w here finance leases are t reat ed as condit ional sales agreement s. The only difference bet w een int ernat ional
leasing and loans w ill be t he document at ion, w it h dow n payment s, payment st reams, and lease-end opt ions t he
same as offered under Equipment Loans t o Foreign Buyers. The various kinds of leasing arrangement s available
in t he U.S. market are not yet feasible in most cases for cross-border leasing t ransact ions. There are how ever,
at t empt s t o develop more flexible int ernat ional leasing st ruct ures for export financing. Operat ing leases may be
feasible for export s of large equipment w it h a long economic life relat ive t o t he lease t erm.
Cross-border leasing is a leasing arrangement w here lessor and lessee are sit uat ed in t w o different count ries.
This raises significant addit ional issues relat ing t o t ax avoidance and t ax shelt ers.
Cross-border leasing has been w idely used in some European count ries, t o arbit rage t he difference in t he t ax
law s of different count ries. Typically, t his rest s on t he premise t hat , for taxpurposes, some assign ow nership and
t he at t endant depreciat ion allow ances t o t he ent it y t hat has legal t it le t o an asset , w hile ot hers assign it t o t he
ent it y t hat has t he most of t he use (legal t it le being only one of several fact ors taken int o account ). In t hese
cases, w it h sufficient ly long leases (oft en 99 years), an asset can end up w it h t w o effect ive ow ners, one each in
different count ries, t his is oft en referred t o as a double-dip lease.
Oft en t he original ow ner of an asset is not subject t o t axat ion in any count ry and t herefore not able t o claim
depreciat ion. The t ransact ion oft en involves an ent it y selling an asset (such as sew erage syst em or pow er plant )
t o an invest or (w ho can claim depreciat ion), and long-t erm leasing it right back (oft en referred t o as a sale
leaseback).

Leasing t echniques had been used for financing purposes for several decades t hroughout t he w orld. The pract ice
w as developed as a met hod of financing aircraft . Several airlines ent it ies in t he early 1970s w ere unprofit able
and very capit al int ensive. These airlines had no need for t he depreciat ion deduct ions generat ed by t heir aircraft
and w ere significant ly more int erest ed in reducing t heir operat ing expenses. A very prominent bank purchased
aircraft and leased t hem t o t he airlines and because t he bank w as able t o claim depreciat ion deduct ions for
t hose aircraft , t he bank w as able t o offer lease rat es t hat w ere significant ly low er t han t he int erest payment s
t hat airlines w ould have t o pay on an aircraft purchase loan (and most commercial aircraft flying t oday are
operated under a lease). In t he United States, t his spread int o leasing t he asset s of U.S. ent it ies and governmental
ent it ies and event ually evolved int o cross-border leasing.

 One significant evolut ion of t he leasing indust ry involved t he collat eralizat ion of lease obligat ion s in sale
leaseback t ransact ions. For example, an ent it y w ould sell an asset t o a bank, t he bank w ould require lease
payment and give an ent it y an opt ion t o repurchase t he asset , t he lease obligat ions w ere low enough (due t o t he
depreciat ion deduct ions t he banks w ere now claiming) so t hat t he ent it y could pay for t he lease obligat ions and
fund t he repurchase of t he asset by deposit ing most but not all of t he sale proceeds in an int erest bearing
account . This result ed in t he ent it y having pre-funded all of it s lease obligat ions as w ell as it s opt ion t o repurchase
t he asset from t he bank for less t han t he amount received in t he init ial sale of t he asset so t he ent it y w ould be
left w it h addit ional cash aft er having pre-funded all of it s lease obligat ions.

This gave t he appearance of ent it ies ent ering int o leasing t ransact ions w it h banks for a fee. By t he lat e 1990s
many of such leasing t ransact ions w ere w it h ent it ies in Europe. How ever, in 1999 cross border leasing in t he
United States was “ st opped” by t he effect ive shutdow n of LILOs (lease-in/ lease out s). LILOs w ere significant ly
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more complicat ed t han t he t ypical lease w here an ow ner (for example) w ould lease an asset t o a bank and t hen
lease it back from t he bank for a short er period of t ime.

Cross-border leasing has been in pract ice as a means of financing infrast ruct ure development in emerging
nat ions. Cross-border leasing may have significant applications in financing infrast ruct ure development in emerging
nat ions such as rail and air t ransport equipment , t elephone and t elecommunicat ions equipment and asset s
incorporat ed int o pow er generat ion and dist ribut ion syst ems and ot her project s t hat have predict able revenue
st reams.
A major object ive of cross-border leases is t o reduce t he overall cost of financing t hrough ut ilizat ion by t he lessor
of t ax depreciat ion allow ances t o reduce it s t axable income. The t ax savings are passed t hrough t o t he lessee as
a low er cost of finance. The basic prerequisit es are relat ively high t ax rat es in t he lessor ’s count ry liberal
depreciat ion rules and eit her very flexible or very formalist ic rules governing t ax ow nership.

Ot her import ant object ives of cross border leasing include t he follow ing:
• The lessor is oft en able t o ut ilize nonrecourse debt t o finance a subst ant ial port ion of t he equipment cost . The
debt is secured by among ot her t hings, a mort gage on t he equipment and by an assignment of t he right t o receive
payment s under t he lease.
• Also, depending on t he st ruct ure, in some count ries t he lessor can ut ilize very favourable “ leveraged lease”
financial account ing t reat ment for t he overall t ransact ion.
• In some count ries, it is easier for a lessor t o repossess t he leased equipment follow ing a lessee default because
t he lessor is an ow ner and not a mere secured lender.
• Leasing provides t he lessee w it h 100% financing.

While details may differ from one t ransact ion t o anot her, most leasing st ruct ures are essent ially similar and
follow t he “ sale-leaseback” pat t ern. The principal players are (i) one or more equit y invest ors; (ii) a special
purpose vehicle formed t o acquire and ow n t he equipment and act as t he lessor; (iii) one or more lenders, and (iv)
t he lessee. The lease it self is a “ t riple-net lease” under w hich t he lessee is responsible for all cost s of operat ion,
maint enance and insurance.

In many t ransact ions, t he lessee’s fixed payment obligat ions are prefunded or “ defeased” t hrough an up-front
payment (in an amount equal t o t he present value of t he fixed payment obligat ions) t o a financial ent it y t hat
assumes such obligat ions. The benefit s of defeasance include (i) t he lessee can lock in it s financial savings by
making t he defeasance payment ; (ii) by rout ing t he lease payment s t hrough t he defeasance ent it y’s jurisdict ion,
w ithholding taxes applicable to lease payment s in t he lessee’s jurisdiction may possibly be avoided; (iii) defeasance
serves t o some extent as a credit enhancement technique for t he lessor, and (iv) defeasance may eliminate or
reduce currency risk exposure.

In order for t he lessor t o obt ain t he t ax benefit s associat ed w it h equipment leasing, most count ries require t hat
t he lease be t reat ed as a “ t rue lease” for t ax purposes, as opposed t o a condit ional sale or ot her secured
financing arrangement . This object ive generally can be sat isfied if t he lessor has “ t ax ow nership” of t he leased
equipment.

Each count ry applies different rules for det ermining w het her t he part y act ing as lessor under a cross-border
lease is t he “ ow ner ” of t he leased asset for tax purposes and is t hereby ent it led t o claim tax allow ances. In t he
United States and some ot her count ries, t he principal focus is on w het her t he lessor possesses subst ant ially all
att ributes of economic ow nership of t he leased asset . Ot her count ries such as t he United Kingdom and Germany
apply more formalist ic propert y law concept s and focus primarily on t he locat ion of legal t it le, alt hough t hese
count ries usually also require t hat t he lessor have some att ributes of economic ow nership or, at least , t hat t he
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lessee have only a minimal economic int erest in t he equipment . In Japan, ow nership of legal t it le is essent ial, but
t he lessor is only required under current law t o obt ain nominal incident s of economic ow nership (all t hat is
required is t hat t he lease w ill provide a ret urn of t he equit y invest ment plus a pre-t ax profit of 1% of equipment
cost ). While Japan does have det ailed t ax lease guidelines, t hese guidelines are designed primarily t o circumscribe
t he t ax benefit s available t o t he lessor in a cross-border lease t o prevent undue t ax deferral; t hey do not require
t he lessor t o have a significant economic int erest in t he leased equipment .

The non-t ax issues associat ed w it h cross-border leasing can best be described by reference t o t he various
st ruct ural risks t hat may arise in a given t ransact ion and must be addressed in t he document at ion.

8. REGULATORY ASPECTS OF LEASING

A Leasing Company is a Non-Banking Financial Company as per t he FAQs given in t he RBI Website https:/ /
www.rbi.org.in. So, in a way, it has t o get it self registered w it h RBI. The reason is t hat in terms of Sect ion 45-IA
of t he RBI Act , 1934, no Non-banking Financial company can commence or carry on business of a non-banking
financial inst it ut ion w it hout obt aining a cert ificat e of regist rat ion from t he RBI.
Furt her, as per Sect ion 45-IA of t he said Act , no non-banking financial company shall commence or carry on t he
business of a non-banking financial inst it ut ion w it hout -
(a) obt aining a cert ificat e of regist rat ion issued under t his Chapt er; and
(b) having t he net ow ned fund of t w ent y-five lakh rupees or such ot her amount , not exceeding t w o hundred lakh
rupees, as t he RBI may, by not ificat ion in t he Official Gazette, specify.

M eaning of “net owned fund”

It means-
(a) t he aggregat e of t he paid-up equit y capit al and free reserves as disclosed in t he lat est balance-sheet of t he
company aft er deduct ing t herefrom- (i) accumulat ed balance of loss; (ii) deferred revenue expendit ure; and (iii)
ot her int angible asset s; and
(b) furt her reduced by t he amount s represent ing invest ment s of such company in shares of - (i) it s subsidiaries;
(ii) companies in t he same group; (iii) all ot her non-banking financial companies;

Furt her, an Equipment Leasing Company has been an eligible NBFC for t he purpose of acceptance of deposit s
by NBFCs defined in paragraph 2(1) of t he Non-Banking Financial Companies Accept ance of Public Deposit s
(Reserve Bank) Direct ions, 1998. As per t he said direct ions, Equipment Leasing (EL) means any company w hich is
a financial inst it ut ion carrying on as it s principal business, t he act ivit y of leasing of equipment .
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LEASING-PRACTICAL
EVALUATION FROM THE POINT OF VIEW OF LESSEE & BORROW ER

QUESTION NO. 1A ABC Ltd. is considering t o acquire an addit ional computer. It has t w o opt ions :
(i) To purchase t he computer for ` 22,00,000 and
(ii) To lease t he computer on an annual rental (payable at t he end of t he years) of `5,00,000 plus 10% of gross
revenue from t ime services. An amount of `6,00,000 is also payable at t he end of years 3.
The revenues from comput er are est imat ed at ` 22,50,000, ` 25,00,000 and ` 27,50,000 for 3 years. The comput er
salvage value is ` 10,00,000 at t he end of 3rd year.
Annual operat ing cost (excluding depreciat ion and lease rent ) is est im at ed at ` 2,00,000 per annum and an
addit ional revenue expense of ` 2,00,000 is payable for t raining in t he beginning of t he 1st year (bot h t hese cost s
are t o be borne by t he lessor in case of lease).
Funds for purchase are t o be acquired at t he rat e of 16% and are repayable ` 5,00,000, ` 8,50,000 and ` 8,50,000
at t he end of 3 years respect ively.
Firm pays t ax at t he rat e of 50% and provides depreciat ion at st raight line met hod.
The management approaches you t o advice ,w hich alt ernat ive w ould be recommend and w hy ?

QUESTION NO.1BBright Limit ed is considering t o acquire an addit ional sophist icat ed comput er t o augment it s
t ime-share computer services t o it s client s. It s has t w o opt ions :Eit her,
(a) t o purchase t he computer at a cost of ` 44,00,000 Or,(b) t o take t he computer on lease for 3 years from a
leasing company at an annual lease rent al of ` 10 lacs plus 10% of t he gross t ime-share service revenue. The
agreement also requires an addit ional payment of ` 12 lacs at t he end of t he t hird year. Lease rentals are payable
at t he year end and t he computer revert s back t o lessor after period of cont ract .The company est imat es t hat t he
computer w ill be w ort h ` 20 lacs at t he end of t he t hird year.The Gross revenue t o be earned are as follow s :—
Year ` in lacs
1 45
2 50
3 55
Annual operat ing cost (excluding depreciat ion/ lease rent al) are est imat ed at ` 18 lacs w it h an addit ional revenue
cost of ` 2 lacs for start up and t raining at t he beginning of t he first year. These costs are to be borne by the
lessee in case of lease arrangement also. The company proposes t o borrow @ 16% int erest t o finance t he
purchase of t he comput er and t he repayment s are t o be made as per t he follow ing 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 t he purpose of t his comput at ion assume t hat t he company uses t he st raight line met hod of depreciat ion on
asset s and pays 50% tax on it s income.You are required t o analyse and recommend t o t he company w hich of t he
t w o opt ions is better. [PV fact or @ 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 t o t he Quest ion No. 1 solved in class.The only difference is t hat in Q.No. 1 Operat ing cost
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and Training cost w ere borne by Ow ner i.e Lessor and Borrow er,but in t his quest ion it is borne by Users i.e Lessee
and Borrow er.
Now since it is borne by bot h Lessee and Borrow er it become a common it em 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
paym ent @ 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 t he comput re is
bought . Therefore, purchase of comput er is suggest ed.

Internal Rate Of Return (IRR) IN CASE OF LESSOR

QUESTION NO. 2 Armada Leasing Company is considering a proposal t o lease out a school bus. The bus can be
purchased for ` 5,00,000 & in t urn, be leased out at `1,25,000 per year for 8 years w it h payment s occurring at t he
end of each year:
(i)Estimate t he int ernal rat e of ret urn for t he company assuming t ax is ignored.
(ii) What should be t he yearly lease payment charged by company in order t o earn 20% rat e of ret urn
(iii)Calculate t he annual lease rent t o be charged so as t o amount t o 20% aft er t ax rat e of ret urn, based on t he
follow ing assumpt ions:
(a) Tax rate is 40%;(b) St raight line depreciat ion; (c) Annual expenses of ` 50,000;(d) Resale(Salvage) value ` 1,00,000.

Breakeven Lease Rental FOR LESSEE

QUESTION NO. 3ABet a Lt d. is considering t he acquisit ion of a personal comput er cost ing Rs. 50,000. The effec-
t ive life of t he comput er is expect ed t o be five years. The company plans t o acquire t he same eit her by borrow ing
` 50,000 from t he bankers at 15% interest per annuam or by lease. The company want s t o know t he lease rentals
t o be paid annually w hich w ill mat ch t he loan opt ion. The follow ing informat ion is provided t o you:
(a) The pricinpal amount of t he loan w ill be paid in five annual equal inst allment s.
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(b) Interest , lease rentals, principal repayment is t o be paid on last day of each year.
(c) The full cost of t he comput er w ill be w rit t en off over t he effect ive life of comput er on a st raight -line basis and
t he same w ill be allow ed for t ax purposes.
(d) The company’s effect ive tax rate is 40% and t he after tax cost of capital is 9%.
(e) The computer w ill be sold for ` 1,700 at t he end of t he 5t h year. The commission on such sales is 9% on t he
sale value and t he same w ill be paid.
You are required to compute t he annual lease rentals payable by Beta Ltd. w hich w ill result in indifference t o
t he loan opt ion.

QUESTION NO.3BA company is planning t o acquire a machine cost ing `500,000. Effect ive life of t he machine is
5 years. The company is considering t w o opt ions. One is t he purchase t he machine by lease and t he ot her is t o
borrow `5,00,000 from it s bankers at 10% interest p.a. The Principal amount of loan w ill be paid in 5 equal
installment s t o be paid annually. The machine w ill be sold at `50,000 at t he end of 5t h year. Follow ing furt her
informat ions are as given :
(a) Principal, interest , lease rentals are payable on t he last day of each year.
(b) The machine w ill be fully depreciated over it s effect ive life.
(c) Tax rate is 30% and after tax Discount Rate t o be used for t he above analysis is 8%
Compute t he lease rentals payable w hich w ill make t he firm indifferent t o t he loan opt ion.
Solution:
(a) Borrowing Option :
5,00 ,000
Annual Principal Amount = = ` 1,00,000/ - ;
5
5,00 ,000
Annual Depreciat ion = = ` 1,00,000/ -
5
Additional Analysis: Why Sale Value of ` 50000 has not been considered? Since it is w ritten in t he quest ion t hat
machine w ill be fully depreciat ed over it s 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 Am t. 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
Written Dow n Value at t he end of 5 year 0
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Less : Sale Value 50,000

Profit on Sale 50,000
Tax @ 30% t o be paid on profit 15000
Therefore Salvage Value Adjusted For Tax = ` 50,000 - ` 15,000= ` 35,000
OR
Since ent ire amount has been depriciat ed, full sale amount of ` 50,000 w ill represent profit . Hence am ount
Received Net of Tax = ` 50,000 - ` 15,000 = ` 35,000
Let t he Lease Rentals be X w hich w ill make t he firm indifferent t o t he loan opt ion:
Therefore w e 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 follow ing invest ment proposal is available t o XYZ Lt d.

Init ial Invest ment s ` 18 crores
Life of M achine 3 years
Salvage value of machine aft er 3 year ` 180 lakh
Depreciat ion (WDV M et hod) 40 %
From above dat a compute t he BELR, if ot her opt ion of borrow ing at a rat e of int erest of 17% p.a is available.
Furt her, you may also assume t hat t he cost of capital t o t he company is 12% and applicable tax rate is 35%. Use
Equat ed Annual Inst alment M et hod.
Solution:
Evaluation of Lease Option
Let Lease Rent al be ` X
Discount Rat e = 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. Repaym ent 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 Installm ent Interest Principle Closing Balance
Balance Paid @ 17% Repaym ent
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 dat e 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.3D M / s ABC Ltd. is t o acquire a personal computer w it h modem and a printer. It s price is ` 60,000.
ABC Lt d. Can borrow `60,000 from a commercial bank at 12% int erest per annum t o finance t he purchase. The
principal sum is t o be repaid in 5 equal year end inst allment s. ABC Lt d. can also have t he comput er on lease for
5 years.The firm seeks your advice t o know t he maximum lease rent payable at each year end. Consider t he
follow ing addit ional informat ion:
(i) Int erest on bank loan is payable at each year end.
(ii) The full cost of t he comput er w ill be w rit t en off over t he effect ive life of comput er on st raight line basis. This
is allow ed for t ax purposes.
(iii) At t he end of year 5, t he computer may be sold for `1,500 t hrough a second hand dealer, w ho w ill charge 8%
commission on t he sale proceeds.
(iv) The company’s effect ive tax rate is 30%.
(v) The cost of capit al is 11%.
Suggest t he maximum annual lease rent al for ABC Lt d. PV Fact or at 11%
Year 1 2 3 4 5
PVF 0.901 0.812 0.731 0.659 0.593
Solution:
(a) Workings:
60 ,000
(i) Annual loan repayment : = = ` 12,000
5
(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 fact or 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 flow s 42,425_
Calculation of Annual Lease Rental:
Let L be t he lease rent al.
Therefore t o match loan Opt ion w it h Lease Opt ion, Present Value Of Out flow s under Lease Opt ion must also be
`42,425.
Therefore w e have : L  0.70  3.696 = `42424  L = `16400
Hence, Annual Lease Rent als payable by Bet a Lt d. should be `16400

Different Plan Under Lease Rentals

QUESTION NO. 4AThe follow ing data relate t o t he TATA Leasing Ltd.(Lessor):
(i) Invest ment Out lay / Cost of Asset = 100 lakh (ii) Lessor ’s Desired Ret urn= 20%
(iii) Lease t erm = 5 years. (iv) Residual value (aft er primary period) = Nil
Compute Annual Lease Rent als (or Ballooned Payment in case of d ) under t he follow ing alt ernat ives:
(a) Equal Annual Plan
(b) St epped up Plan (15% increase per annum)
(c) Deferred Plan (deferment period of 2 years)
(d) Ballooned Plan (annual rent al of `10 lakh for year 1-4)

QUESTION NO.4BAssuming lease amort ised in 5 years, calculat e rent al st ruct ure from t he follow ing :
Invest ment 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 t he fourt h year and no payment s in first t hree years)
(d) Deffered plan (deferment of 2 years). Calculate Lease Rent als.
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 Lt d. is in t he business of manufact uring bearings. Some more product lines are being
planned t o be added t o t he exist ing system. The asset required may be brought or may be taken on lease. The
cost of m achine is `40,00,000 having a useful life of 5 years w it h t he salvage value of ` 8,00,000. The full
purchase value of machine can be financed by 20% loan repayable in five equat ed inst alment s falling due at t he
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end of each year. Alternat ively, t he machine can be procured on a 5 years lease, year-end lease rent als are `
12,00,000 per annum. The Company follow s t he w rit t en dow n value met hod of depreciat ion at t he rat e of 25%.
Company’s tax rate is 35 per cent and cost of capital is 16 per cent .
(i)Advise t he company w hich opt ion it should choose - lease or borrow.
(ii)Evaluate t he proposal from t he lessor ’s point of view examining w het her leasing t he machine is financially
viable at 14% cost of capit al (Det ailed w orking not es should be given. Calculations can be rounded off t o ` lakhs)

QUESTION NO.5BEngineers Lt d. is in t he business of manufact uring nut bolt s. Some more product lines are being
planned t o be added t o t he 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 t he rat e of 20% int erest repayable in five equal
instalment s inclusive of interest falling due at t he end of each year. Alternat ively, t he machine can be procured on
a 5 years lease, year end lease rent als being ` 6,00,000 per annum. The Company follow s t he w rit t en dow n value
met hod of depreciat ion at t he rate of 25 per cent . Company’s tax rate is 35 per cent and cost of capital is 14 per
cent .
(i)Advise t he company w hich opt ion it should choose – lease or borrow.
(ii)Assess t he proposal from t he lessor ’s point of view examining w het her leasing t he machine is financially
viable at 14 per cent cost of capit al.
Det ailed w orking not es 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%
Calculation of Net Cash Flow :
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
Present Value of Total Outflows 13,67,085
Working Notes :
(1) Equal Annual Loan inclusive of Interest :
20,00,000 20,00,000
Equal Annual Loan inclusive of Int erest = = = ` 6,68,673
PVAF (20%,5 Years) 2.991
(2) Schedule of Depreciation
Year Opening W DV Depreciation Closing W DV
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 Am ount
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 t o borrow & buy & not t o go for leasing as NPV of cash out flow s is low er in case of
buying alt ernat ive.
(ii) Evaluation from Lessor’s Point of V iew :
(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 Inflow s 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 Inflow s 4,95,505 4,00,841 3,29,695 2,74,586 2,31,148
Evaluation :
Aggregate Present Value of Cash Inflow s 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 Inflow s 19,52,928
Cost of t he M achine 20,00,000
Net Present Value -47,072
Decision: Since Net Present Value is negat ive Leasing at t his rate is not feasible.

QUESTION NO.5CABC Lt d. is cont emplat ing having an access t o a machine for a period of 5 years. The Company
can have t he use of t he machine for t he st ipulat ed period t hrough leasing arrangement s or t he requisit e amount
can be borrow ed t o buy t he machine.In case of leasing, t he company received a proposal t o pay annual end of
year rent of `2.4 lakhs for a period of 5 years.In case of purchase (w hich cost s `10,00,000/ -) t he company w ould
have a 12%, 5 year loan t o be paid in equat ed inst allment s, each inst allment becoming due at t he beginning of
each year. It is est imated t hat t he machine can be sold for `2,00,000/ - at t he end of 5t h year. The company uses
st raight line met hod of depreciat ion. Corporate tax rate is 30%. Post tax cost of capital of ABC Ltd. is 10%.You are
required to advice
(i) Whet her t he machine should be bought or taken on lease.
(ii) Analyse t he financial viabilit y from t he point of view of t he lessor assuming 12% t ax cost of capit al.
PV of Rs.1 @ 10% for 5 years PV of Rs.1 @ 12% for 5 years
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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 Repaym ent 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)
Present Value of Outflow under Borrowing (Loan Option)
Year Interest (1 – tax) Principal Am t. 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)
Present Value of Total Outflows 6,67,297
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 V iew (`)
Cost of M achine (-) 10,00,000
PV of Post t ax lease Rent al (` 2,40,000 x 0.7 x 3.605) 6,05,640
PV of Depreciat ion t ax 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.5D The Finance manager of ABC Corporat ion is analyzing firms policy regarding comput ers w hich
are now being leased on yearly basis on rental amount ing t o ` 1,00,000 per year. The computers can be bought for
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`5,00,000. The purchase w ould be financed by 16% and t he loan is repayable in 4 equal annual inst allm ent s.
On account of rapid technological progress in t he computer indust ry, it is suggested t hat a 4-year economic life
should be used inst ead of a 10-year physical life. It is est imat ed t hat t he comput ers w ould be sold for `2,00,000
at t he end of 4 years.
The company uses t he st raight line met hod of depreciat ion. Corporat e t ax rat e is 35%.
(i) Whet her t he equipment be bought or be taken on lease?
(ii)Analyze t he financial viabilit y from t he point of view of t he lessor, assuming 14% cost of capital.
(iii)Determine t he minimum lease rent at w hich lessor w ould break even.
Solution:
(i)Evaluation From Point Of V iew Of Borrower-PV Of Outflow For Borrower
Year Interest Principal Tax Salvage Net
Net Repaym ent 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 PVF@10.4% 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 t his opt ion.
Working Notes:
5,00,000
1.Equated Annual Instalment = = ` 1,78,699 (rounded)
2.798
5,00,000 - 2,00,000
2.Depreciation p.a =
4
3.Kd = 16 ( 1- .35) = 10.4%
4.Bifurcation Table
Opening Interest Principal Closing
Year Balance @16% Instalments Repaym ent Balance
` ` ` ` `
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. 6 Evergreen Pvt . Lt d. is considering t he possibilit y of purchasing a mult ipurpose machine(asset )
w hich cost ` 10.00 lakhs. The machine(asset ) has an expect ed life of 5 years. The machine(asset ) generat es Rs.
6.00 lakhs per year before Depreciat ion and Tax, and t he M anagement want s t o dispose t he machine(asset ) at
t he end of 5 years w hich w ill fet ch Net ` 1.00 lakh. The Depreciat ion allow able for t he machine(asset ) is 25% on
w ritten dow n value and t he Company’s Tax rate is 50%. The company approached a NBFC for a five year Lease for
financing t he asset w hich quoted a rate of ` 28 per t housand per mont h.Lease Rental is payable annually. The
Company w ant s you t o evaluate t he proposal w it h purchase opt ion t aking t he Cost of Capit al is 12 % and for
lease opt ion it w ant you t o consider a discount rat e 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

W HEN LOAN IS TAKEN FOR PAYING LEASE RENT

QUESTION NO.7 R Ltd., requires a machine for 5 years. There are t w o alternat ives eit her t o take it on lease or buy.
The company is reluctant t o invest init ial amount for t he project and approaches t heir bankers. Bankers are ready
t o finance 100% of it s init ial required amount at 15% rat e of int erest for any of t he alt ernat ives.
Under lease option, upfront Securit y deposit of `5,00,000/ -[to be arranged by lessee t hrough borrow ing] is payable
t o lessor w hich is equal t o cost of machine. Out of w hich, 40% shall be adjust ed equally against annual lease
rent . At t he end of life of t he machine, expect ed scrap value w ill be at book value [ it means profit loss on sale on
machine w ill be zero] aft er providing, depreciat ion @ 20% on w rit t en dow n value basis.
Under buying opt ion, loan repayment is in equal annual installm ent s of principal amount , w hich is equal t o
annual lease rent charges [It means annual lease rent is `1,00,000]. How ever in case of bank finance for lease
opt ion, repayment of principal amount equal t o lease rent adjusted every year, and t he balance at t he end of 5t h
year.
Assume Income tax rate is 30%, interest is payable at t he end of every year and discount rate is @ 15% p. a .The
follow ing discount ing fact ors are given:
Year 1 2 3 4 5
Fact or 0.8696 0.7562 0.6576 0.5718 0.4972
Which opt ion w ould you suggest on t he basis of net present values?
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Equated Annual Loan-Amount Paid At The Beginning Of The Year

QUESTION NO.8 ABC Company has decided t o acquire a `5,00,000 pulp cont rol device t hat has a useful life of t en
years. A subsidy of ` 50,000 is available at t he t ime device is acquire and placed int o service. The device w ould be
depreciated on st raight-line basis and no salvage value is expected. The company is in t he 50% tax bracket . If t he
acquisit ion is financed w it h a lease, lease payment s of ` 55,000 w ould be required at t he beginning of each year.
The company can also borrow at 10% repayable in equal inst alment s inclusive of int erest . Debt payment s w ould
be due at t he beginning of each year :
(i) What is t he present value of cash out flow for each of t hese financing alt ernat ives, using t he aft er-t ax cost of
debt?
(ii) Which of t he t w o alt ernat ives is preferable ?

Calculation Of Diminishing Lease Rental

QUESTION NO.9AFair finance a leasing company has been approached by a prospect ive cust omer int ending t o
acquire a asset cost ing ` 3crores.The cust omer in order t o leverage his tax posit ion has requested a quote for a
t hree year lease w it h rent als payable at t he end of each year but in a diminishing (reducing)manner such t hat
t hey are in t he rat io of 3:2:1.Depreciat on can be assumed t o be on st raight line basis and Fair finance’s marginal
tax rate is 35%.The target rate of ret urn for Fair Finance on t he t ransact ion is 10%. Calculate lease rental t o be
quot ed for lease of t hree years.

QUESTION NO.9BClassic Finance,a Leasing Company, has been approached by A prospect ive cust omer intending
t o acquire a machine w hose cash dow n price is ` 6 crores. The cust omer, in order t o leverage his tax posit ion, has
request ed a quot e for a t hree year lease w it h rent als payable at t he end of each year but in a diminishing manner
such t hat t hey are in t he rat io of 3: 2: 1. Depreciat ion can be assumed t o be on WDV basis at 25% and classic
finance’s marginal tax rate is 35%.The target rate of ret urn for classic finance on t he t ransact ion is 10%.You are
required to calculate t he lease rent s t o be quoted for t he lease for t hree years.Ignore Salvage Value & Profit &
Loss On Salvage Value .
Solution:
Additional Analysis:
1. The given quest ion is asked from t he point of view of Lessor
2. Recall Concept " Calculat ion Of Annual Lease Rent For Lessor When Discount Rat e 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 / W DV 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 t he normal annual lease rent w ere t o be “ X” t hen
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.10 M / s Gama & Co. is planning of inst alling a pow er saving machine and are considering buying
or leasing alt ernat ive. The machine is subject t o st raight line met hod of depreciat ion. Gama & Co. can raise debt
at 14% payable in five equated annual instalment s of ` 1,78,858 each, at t he beginning of t he year. In case of
leasing, t he company w ould be required t o pay an annual end of year rent of 25% of t he cost of machine for 5
years.The Company is in 40% t ax bracket . The salvage value is est imated at ` 24,998 at t he end of 5 years.
Evaluate t he t w o alt ernat ives and advise t he company by considering aft er t ax cost of debt concept under bot h
alternat ives.P.V. Fact ors 0.9225, 0.8510, 0.7851, 0.7242, 0.6681 respect ively for 1 t o 5 years.
Solution:
Cost of M achine
(1)Calculation of Cost of M achine : 178858=
1 + PVAF (14%, 4 years)
 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 – – – – –
699998 – 24998
(3)Calculation of Depreciation : Depreciat ion = = ` 1,35,000 p.a.
5
(4)Calcualtion of Discount Rate : Kd = Int erest (1 – t ax) = 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) PVAF@8.4% Present Value
1-5 1,75,000 (1 – .40)=105000 3.9509 414844.50
Present Value of Outflow under Borrowing (Loan Option)
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 t o opt for leasing as t he t ot al present value of cash out flow is low er by `
55095.50.

Quotations From Two Lessor

Question No.11 P Lt d had planned t o acquire a machine(asset ) cost ing `50 Lakhs t hrough leasing. Quot at ions
from 2 leasing companies have been obt ained w hich are summarized:
Quote A Quote B
Lease t erm 3 years 4 years
Init ial lease rent (year 0) `5.00 Lakhs `1.00 Lakh
Annual lease rent payable at t he end `21.06 Lakhs `19.66 Lakhs
P Ltd evaluates invest ment proposals at 10% cost of capital and it s effect ive tax rate is 30%. Terminal payment in
bot h t he cases is negligible and may be ignored.M ake calculations and evaluate w hich quote is beneficial t o P
Lt d. Present value fact ors at 10% rat e for years 1-4 are respect ively 0.91, 0.83, 0.75 and 0.68. Considerat ions may
be rounded off t o 2 decimals in Lakhs.

DEPRECIATION

QUESTION NO.12AThe original cost of t he asset is ` 2,50,000.The useful life of t he asset is 10 years and net
residual value is est imat ed t o be ` 50,000. Calculat e t he amount of depreciat ion t o be charged every year under
SLM ?
Solution:
Cost of Asset s - Salvage Value 2 ,50 ,000 - 5 0 ,000
Depreciat ion p.a = = =`20,000
Life Of Asset 10 Years

QUESTION NO.12BThe 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 Company follow s the w rit t en dow n value method of depreciat ion at t he rat e of 25 per cent .Calculate
Depreciat ion of each year.
Solution :
Schedule of Depreciation
Year Opening W DV Depreciation Closing W DV
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 Asset s=`160 ;Life : 5Years;Salvage Value = `10. Calculate Depreciat ion as per Sum of
Years Digit M et hod?
Solution :
Amount t o 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 V iew

From t he lessor ’s view point , BELR is t he minimum (floor) lease rental, w hich he should accept . In t his case also
NAL should be zero. Any lease rent below BELR should not be accept ed. It is t o be not ed t hat w hile comput ing
NAL, t he over all cost of capital of t he firm should be used. The computat ion of BELR from lessor ’s point of view
can be underst ood w it h t he help of follow ing illust rat ion.

QUESTION NO.13 Wit h t he follow ing dat a available compute t he BELR t hat ABC Lt d. should charge from lessee.
Cost of Asset ` 150 Lakh
Expected Useful Life 5 year
Salvage Value of M achine at t he end of 5 years ` 10 lakh
Rat e of Depreciat ion (WDV) 25%
Ko 14%;
Tax Rate 35%
Asset w ill const it ut e a separat e block for depreciat ion propose.
Solution:
PV Of Cash Out flow = PV Of Cash Inflow s [ Also st udent 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 Rent al x .65 x 3.433 + 27,34,184 + 11,99,478
Annual Lease Rent al = `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 dat e 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.14 X Lt d. had only one w at er pollut ion control machine(asset) which was subject to rate of depreciation
of 100% in t he very first year of inst allat ion.Due t o fund crunch, X Lt d. decided t o sell t he machine(asset ) w hich
can be sold in t he market t o anyone for `5,00,000.Understanding t his from a reliable source. Y Ltd came forward
t o buy t he machine(asset ) for `5,00,000 and lease it t o X lt d for lease rent al of `90,000 p.a. for 5 year X Lt d.
decided t o invest t he net sale proceed in a risk free deposit , fet ching yearly int erest of 8.75% t o generat e some
cash flow. It also decided t o relook t he ent ire issue afresh after t he said period of 5 years.
Anot her company, Z Ltd. also approached X Ltd proposing t o sell a similar machine(asset ) for `4,00,000 t o t he
lat t er and undert ook t o buy it back at t he end of 5 year for `1,00,000 provided t he maint enance w ere ent rust ed t o
X Lt d. for yearly charge of `15,000. X Lt d. w ould ut ilize t he net sale proceeds of t he old machine(asset ) t o fund t his
machine(asset ).The marginal rate of tax of X Ltd. is 34% and it s w eighted average cost of capital is 12%. Which
Alt ernat ive w ould you recommend ?
Discount ing Fact ors @ 12% are:
0.893 0.797 0.712 0.636 0.567

Evaluation W hen Housing Loan Is Swapped

QUESTION NO.15 You have a housing loan w it h one of India’s t op housing finance com panies. The amount
out st anding is ` 1,89,540. There are five more inst alment s t o go, each being ` 50,000. Anot her housing finance
company has offered t o take over t his loan on a seven year repayment basis. You w ill be required t o pay ` 36,408
p.a w it h t he first instalment falling a year later. The processing fee is 3% of amount taken over. For swapping you
w ill have t o pay ` 12,000 t o t he first company. Should you swap t he loan ?
[Hint : At 10% PVAF w ill be 4.8684;At 11% PVAF w ill be 4.7122]

Housing Loan Adjustment W hen Interest Rates Are Revised

QUESTION NO.16 M r. A has secured from a housing bank, a six year housing loan of ` 12,00,000. The loan was
st ruct ured as follow s :
Loan Amount — ` 12,00,000
Repayment — Six equat ed annual inst alment s
Reference Base — Prime Lending Rat e
Reference Rat e — 9% on t he dat e of loan
Int erest on Loan — 1 percent age point over reference rat e of 9%
Annual Inst allment — ` 2,75,530
Tw o years after t he loan was granted, t he prime rate moves dow n t o 8% and t he effect ive rate on t he loan
aut omat ically st ood revised t o 9%.
Required :
(1) Determinat ion of Unpaid principal just before rate changes.
(2 )Re-Comput at ion of Equat ed Annual M et hod for revised period at revised rat e

EM I-Instalment Paid At The End

QUESTION NO.17 Fixed Int erest rat es quot ed on housing loans by a nat ionalized bank for t hree different mat urit y
periods are as follow s. Compute EM I for a loan of ` 72,500 for each of t he mat urit ies.
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Option I Option II Option III
Int erest rat e 10% (3 years) 11% (5 years) 12% (10 years)
[Hint : PVAF (.833%,36 mont hs) = 30.99 ; PVAF (.9167%,60 mont hs) = 45.99 ; PVAF (1%,120 mont hs) = 69.70 ]
Solution:
Option I Option II Option III
Annual Int erest 10% 11% 12%
Loan Period 3 years 5 years 10 years
Int erest Rat e adjust ed on one
mont h basis 0.833 0.916 1.000
Loan Amount ` 72,500 ` 72,500 ` 72,500
PVAF
for 36/60/120 mont hs 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.18 W Limited is faced w it h a decision t o purchase or acquire on lease a mini car. The cost of t he
mini car is ` 1,26,965. It has a life of 5 years. The mini car can be obt ained on lease by paying equal lease rent als
annually. The leasing company desires a ret urn of 10% on t he gross value of t he asset . W Limited can also obtain
100% finance from it s regular banking channel.The rate of interest w ill be 15% p.a. and t he loan w ill be paid in
five annual equal instalment s, inclusive of interest .The effect ive tax rate of t he company is 40%. For t he purpose
of t axat ion it is t o be assumed t hat t he asset w ill be w rit t en off over a period of 5 years on a st r aight line
basis.Advise W Limited about t he met hod of acquiring t he car.
Assume all cash flow s are arising at t he beginning of each year.For your exercise use t he follow ing discount
fact ors:
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:
Comput at ion of annual loan repayment inst alment
LoanAmount 1,26,965 1,26,965
= = = `32935 p.a
1 + PVAF(r %, n 1 Years) 1 + PVAF(15 %,5 1 Years) 3.85497836268
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)
Tot al ` 87,459
Cost Of Asset 1,26,965
Computation of Annual lease rentals: = = ` 30,447
1 + PVAF(10 %,5 1 Years) 1 + 3.170
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 flow s under lease financing is ` 81,719 w hile t hat of debt financing (i.e.
ow ning t he asset ) is ` 87,335. Thus leasing has an advant age over ow nership in t his case.

Consumer Finance
QUESTION NO.19 Lenders and Company has come up w it h a special offer for it s cust omers, for purchase of TVs,
Refrigerat ors. Elect ronic equipment and ot her home appliance. Sales persons reveal t he follow ing :
* The offer is available for a minimum purchase of it ems for list price of ` 18,000
* The purchase price can be paid in 12 equal mont hly inst alment s. The first payment is t o be made on t he dat e of
purchase and t he remaining 11 inst alment s are payable each of t he follow ing mont hs, on t he same calendar dat e
of purchase.
* If t he buyers opt t o pay in cash, t hey can get a st eep discount of ` 1173 for each lot of purchases w ort h ` 18,000/
(a) Is t here an int erest element involved in Zero int erest offer ?
(b) If yes, w hat is t he rat e ?
(c) Which offer w ould 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 Lt d. sells comput er services t o it s client s. The company has
recent ly completed a feasibilit y st udy and decided t o acquire an addit ional computer, t he details of w hich are as
follow s
(1) The purchase price of t he comput er is Rs.2,30,000; maintenance, property taxes and insurance w ill be
Rs.20,000 per year. The addit ional expenses t o operate t he computer are est imated at Rs.80,000. If t he computer
is rented from t he ow ner, t he annual rent w ill be Rs.85,000, plus 5% of annual billings. The rent is due on t he last
day of each year.
(2) Due t o compet it ive condit ions, t he company feels t hat it w ill be necessary t o replace t he comput er at t he end
of t hree years w it h a more advanced model. It s resale value is est imat ed at Rs.1,10,000.
(3) The corporat e income t ax rat e is 50% and t he st raight line met hod of depreciat ion is follow ed.
(4) The est imat ed annual revenue billing for t he services of t he new comput er w ill be Rs.2,20,000 during t he first
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year, and Rs.2,60,000 during t he subsequent t w o years.
(5) If t he comput er is purchased, t he company w ill borrow t o finance t he purchase from a bank w it h int erest at
16% per annum. The interest w ill be paid regularly, and t he principal w ill be ret urned in one lump sum at t he end
of t he year 3.Should t he company purchase t he comput er or lease it ?
Assume (i) Cost of Capital as 12%, (ii) St raight Line M et hod of Depreciat ion, (iii) Salvage Value of Rs.1,10,000 and
evaluat e t he proposal from t he point of view of lessor also. Additional Analysis:
1.M aintenance, Property taxes and Insurance are assumed t o be incurred by Ow ner of t he asset unless otherwise
specifically st at ed.
2.Operating Costs are assumed t o be incurred bu User of t he asset unless ot herw ise 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
Paym ent Paym ent et c 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 Rent al Income Received 85,000 85,000 85,000
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Add : 5 % Bill Amount Received 11,000 13,000 13,000

Less : Propert y 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 et hod :
Original Cost - Salvage Value 2 ,30 ,000 - 1,10 ,000
= = 40,000 p.a
Life 3
(4) Profit n Loss on Sale of M achine w ill 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 dat e 1,20,000
Amount t o be w rit t en off 1,10,000
Less : Salvage Value 1,10,000
Profit n Loss on Sale Nil_____

Additional Analysis :
(i) Expenses t o operat e comput er w hich in t he present case is Rs. 80,000 are common t o bot h Leasing as w ell as
Borrow ing opt ion and hence it is ignored.
(ii) Revenue on account of est imat ed annual billing for t he services of t he new comput er w ill common under bot h
leasing as w ell purchasing opt ion and hence accordingly it has been ignored.
(iii) M aintenance , Propert y Tax and Insurance of Rs. 20,000 are supposed t o be paid by ow ner of t he asset .Hence
in our case borrow er and lessor w ill incur t his expenses

QUESTION NO. 2 (Exam Question)(20 M arks)(Study M aterial) ABC Lt d. is considering a proposal t o acquire a
machine cost ing Rs. 1,10,000 payable Rs. 10,000 dow n and balance payable in 10 annual equal inst alment s at
t he end of each year inclusive of int erest chargeable at 15%. Anot her opt ion before it is t o acquire t he asset on
a lease rent al of Rs. 15,000 per annum payable at t he end of each year for 10 years. The follow ing informat ion is
also available.
(i) Terminal Scrap value of Rs. 20,000 is realizable, if t he asset is purchased.
(ii) The company provides 10% depreciat ion on St raight Line M et hod on t he original cost .
[ Addit ional Analysis : It means full 1,10,000 is t o be depreciat ed ]
(iii) Income t ax rat e is 50%.
(iv) Cash Flow should be discount ed at 15 % .
You are required t o compute t he analyse cash flow s and t o advise as t o w hich opt ion is better.
Q.2
Option 1 : Borrowing Option
Working Notes-
In t his opt ions t he firm has t o pay Rs. 10,000 as dow n payment t he balance of Rs. 1,00,000 t oget her w it h int erest
@ 15% is payable in equal inst alment s. The inst alment s amount may be calculat ed by dividing Rs. 1,00,000 by
Rs.1,00,00 0
t he PVAF for 10 years at 15% i.e. Equated Annual Instalment = = Rs. 19,925
5
5.50188
Working Notes-Bifurcation Table
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Opening Interest Principal Closing
Year Balance @15% Instalments Repayment Balance
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 V iew Of Borrower-PV Of Outflow For Borrower
Year Interest Principal Tax Salvage Dow n Net
Net Repaym ent Saving value Paym ent 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 t otal out flow s -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 t he firm opt s t o buy t he asset , t he present value of out flow comes t o Rs. 51,336 ; and in case of lease
opt ion, t he present value of out flow s comes t o Rs. 37,641. Hence, t he firm should opt fo t he lease opt ion. In t hat
way, t he firm w ill be able t o reduce it s cost s by Rs. 13,695 i.e. Rs. 51,336 - Rs. 37,641 in present value terms. This
may also be reffered t o as Net Benefit of Leasing.
Note : St udent s should have discount ed cash flow s under bot h alt ernat ives at aft er t ax cost i.e.15% (1 - 05) =
7.5%. But since quest ion has asked t o discount t he cashflow at 15%, t hat s w hy w e have discounted t he cashflow
at 15%.

QUESTION NO. 3 (Exam Question)(14 M arks) S Ltd. discount s it s cash flow s at 16% and is in t he tax bracket of
35%.For t he acquisit ion of a machinery w ort h Rs.10,00,000, it has t w o opt ions- eit her t o acquire it by t aking a
bank loan @ 15%p.a. repayable in 5 yearly inst alment s of Rs.2,00,000 each plus int erest or t o lease t he asset at
yearly rentals of Rs.3,34,000 for 5 years. In bot h t he cases t he instalment is payable at t he end of t he year.
Depreciat ion is t o be applied @15% using “ Written Dow n Value” (WDV) met hod. You are required t o advise w hich
of t he financing opt ions is t o be exercised and w hy.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 t he Asset = 10,00,000;Interest =15%p.a. ; Year=5year;Yearly
Installment = 2,00,000;Lease ; Depreciat ion=15%p.a WDV M et hod;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
Repaym ent 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 Lt d Company should choose Lease Opt ion.

QUESTION NO. 4 (Exam Question) (8 M arks) XYZ Lt d. requires an equipment cost ing Rs.10,00,000; t he same w ill
be ut ilised over a period of 5 years. It has t w o financing opt ions in t his regard :
(i) Arrangement of a loan of Rs.10,00,000 at an int erest rat e of 13 per cent per annum; t he loan being repayable
in 5 equat ed year end inst alment s;t he equipment can be sold at t he end of fift h year for NET Rs.1,00,000.
(ii) Leasing t he equipment for a period of five years at an Yearly rental of Rs.3,30,000 payable at t he year end.
The rate of depreciat ion is 15 per cent on Written Dow n Value (WDV) basis, income tax rate is 35 per cent and
discount rate is 12 per cent .Advise t he XYZ Ltd. t hat w hich of t he financing opt ions is t o be exercised and w hy.
Q.4
Working Notes:
1.Calculation Of Depreciation As Per W DV
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
Rs.10,00,0 00
Equat ed Annual Inst alment = = Rs.2,84,32 0
3.5172
Working Notes-Bifurcation Table
Opening Interest Principal Closing
Year Balance @13% Instalments Repaym ent Balance
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
Present Value of Outflow under Borrowing (Loan Option)
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)
Calculation of Net Cash Flow :
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 flow s is low er in t he Borrow ing opt ion, XYZ Ltd. should avail of t he loan and
purchase t he equipment .

QUESTION NO.5 (Exam Question)(7 M arks ) ABC Leasing Lt d. has been approached by a client t o w rit e a five
years on an lease asset cost ing Rs.10,00,000 and having est imated salvage value of Rs. 1,00,000 t hereafter. The
company has a after tax required rate of ret urn of 10% and it s tax rate is 50%. It provides depriciat ion @ 331/3%
on w rit t en dow n value of t he asset . What lease w ill provide t he company it s aft er t ax required rat e of ret urn?
Q.5
Additional Analysis:
1.The given quest ion is asked from t he point of view of Lessor
2.Recall Concept " Calculat ion Of Annual Lease Rent For Lessor When Discount Rat e 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 Rent al ( 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 Inflow s 4,25,018
Working Note:
Profit & Loss On Sale Of Asset
Original Cost 10,00,000
(-)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 Lt d. desires t o acquire a diesel generat ing set cost ing Rs. 20 lakh w hich
w ill be used for a period of 5 years. It is considering t w o alt ernat ives
(i) t aking t he generat ing set on lease or
(ii) purchasing t he asset out right by raising a loan. The company has been offered a lease cont ract w it h a lease
payment of Rs. 5.2 lakh per annum for five years payable in advance. Company’s banker requires t he loan t o be
repaid @ 12% p.a. in 5 equated annual instalment s, each installment being due at t he beginning of t he each year.
Tax relevant depreciat ion of t he generat or is 20% as per WDV met hod. At t he end of 5 t h year t he generat or can
be sold at Rs. 2,00,000. M arginal Tax rate of Alfa Ltd. is 30% and it s post tax cost of capital is 10%.Determine:
(i) The Net Advant age of Leasing t o Alfa Lt d. and recommend w het her leasing is financially viable.
(ii) Break Even Lease Rent al.
Q.6
20 20
(1)Calculation of annual installment : = = 4.95 lakhs
1 + PVAF(12%,4Years) 1 + 3.038
(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 PVF@8.4% 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 PVF@8.4% 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 Am ount 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 borrow ing& buying decision saved 14.45
Net Advant age of Leasing [Negat ive] -1.6596
Recommendation:Since Net Advant age of Leasing is negat ive t he 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. Installm ent Opening Closing Principal Interest Tax
value value paym ent 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 Am ount 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 Advant age of Leasing (NAL):
Particulars (Rs. lakh)
Present Value of buying decision 15.344
Less: Present Value of lease decision -16.110
Net Advant age of Leasing - 0.766
Recommendation: Since Net Advant age of Leasing is negat ive t he lease is financially not viable.

(a)Computation of Break Even Lease Rental (BELR) :

Let L be t he BELR t hen

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 w ill 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 Lt d., a small manufact uring firm, is considering t he acquisit ion and
t he use of a machine. Aft er evaluat ing equipment s offered by seven different manufact urers, it has come t o t he
conclusion t hat “ Z” was t he most suitable machine for it s needs. Consequent ly, it has asked t he manufact urer ’s
sales personnel t o provide informat ion on alternat ive financing plans available t hrough t heir financing subsidiary.
The subsidiary present ed t he t w o alt ernat ives.
Alternative I was t o lease t he “ Z” equipment for 7 years, w hich was t he machine’s expected useful life. The
annual lease payment s w ould be Rs. 14,700 and w ould include service and maint enance. Lease payment s w ould
be due at t he beginning of t he year. Lease payment s w ould be fully tax-deduct ible.
Alternative II w ould be t o purchase t he “ Z” equipment t hrough 100 per cent loan from t he financing subsidiary.
The cost of t he machine is Rs. 50,000. It w ould make seven annual payment s of Rs. 9,935 each t o repay t he loan
of Rs. 50,000. Payment s w ould be, at t he end of each year.Rate of Interest is 9%
The company’s marginal tax rate in 44%. It has est imated t hat t he equipment has in expected salvage value of Rs.
1,000. The company plans t o depreciat e t he equipment by using straight-line met hod. The service and maintenance
w ould cost Rs. 3,700 annually.
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You are required t o advice t he company on t he desirablit y of t he 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 Paym ent
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 t he beginning has been taken at t he beginning of t he 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 t he present value of cashflow is low est for Alt ernat ive II, it is suggest ed t o purchase t he machine.
Working Note :Bifurcation of Interest & Principal Com ponent
Year Instalment Interest Balance Principal
Paym ent 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 st udent on Service & M aintenance Cost .The service & maintenance
cost is common under bot h t he alt ernat ives.But t his it em should not be ignored as bot h are paid at different
period of t ime.
Lease Opt ion: Beginning of t he year ; Loan Opt ion :End of t he year
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QUESTION NO.8 (Study M aterial) XYZ Co is planning t o inst all a machine w hich becomes scrap in 3 years. It
requires an invest ment of Rs.180 lakhs and Net scrap realizes Rs. 18 lakhs. The company has follow ing opt ions:
(1) t o take a loan @ 18% and buy t hat machine, t he 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 w hich opt ion is better.
Q.8
Pre t ax rat e is 18%.
Post t ax rat e 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 t ax 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 aft er 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 profit able company w hich is considering t he purchase of a machine cost ing
Rs. 32,00,000. If purchased, AGD Co w ould incur annual maintenance cost s of Rs. 2,50,000.The machine w ould
be used for t hree years and at t he end of t his period w ould be sold for Rs. 5,00,000. Alternat ively, t he 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 rent al w ill be paid in t he beginning
of each year.The company pays tax on profit s 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 borrow ing rate of 7%, evaluate w het her AGD Co should purchase or lease t he new machine.
(2) Suppose a bank had offered t o lend AGD Co Rs. 32,00,000 for a period of five years int erest payable is 5% for
every 6 mont h, t hen you are required t o:
(i) Calculate t he Annual Percentage Rate (APR) or Effect ive Rate p.a implied by t he bank’s offer w it h interest
payable every six mont hs.
(ii) Calculat e t he amount of inst allment payable at t he end of each six-mont h period if t he offered loan is t o be
repaid in equal inst allment s.
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 w rit t en in quest ion t hat t he company pays t ax on profit s at an annual rat e of 30% and all t ax
liabilit ies are paid one year in arrears and tax benefit s are taken 1 year later.
Calculation Of Profit & Loss On Sale Of Asset :
Original Cost 32,00,000
Less:Depeciat ion Till Date 14,00,000
WDV 18,00,000
Less:Sale Value 5,00,000_
Loss On Sale Of Asset at t he 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 aint enance Cost (2,50,000) (2,50,000) (2,50,000)
Tax benefit of
M aint enance 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 Rent al (12,00,000) (12,00,000) (12,00,000)
Tax Benefit on
Lease Rent al 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 t he company should opt for t he same.
(2) (i) Int erest payable every six mont hs means t hat t he bank w ill require 5% every six mont hs accordingly
equivalent annual percent age rat e shall be calculat ed as follow s:[(1+ ·05) 2 – 1] x 100 = 10·25%
(ii) Amount of inst allment t o be paid every 6 mont h w ill be :
= Rs. 32,00,000/ PVAF (5%,10 periods) i.e 7·722 = Rs. 4,14,400
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LEASING -EPQ
1. 1_____ can be defined as a right t o use equipment or capit al goods on payment of periodical amount .
(a) Lease (b) Hire Purchase (c) Factoring (d) Forfait ing

2. ____ is t he act ual ow ner of equipment permit t ing use t o t he ot her part y on payment of periodical amount .
(a) Lessor (b) lessee (c) Factor (d) None of t he above

3. Who acquires t he right t o use t he equipment on payment of periodical amount ?

(a) Lessor (b) lessee (c) Fact or (d) None of t he above

4. In w hich of t he follow ing opt ions t he user of t he asset is t he ow ner of t he asset ?

(a) Lessor (b) lessee

5. Which of t he follow ing is a t ype of lease?

(a) Operat ing Lease (b) Financiaal Lease (c) Sales-Aid Lease (d) All of t hese

6. In w hich of t he follow ing lease, besides t he cost of machinery, t he lessor also bears insurance, maintenance
and repair cost s et c.
(a) Operat ing Lease (b) Financial Lease (c) Sales-Aid Lease (d) Sales and Lease
back

7. Operat ing Lease agreement s may generally be preferred by t he lessee in w hich of t he follow ing circum -
st ances:
(a) When t he long-t erm suit abilit y of asset is uncert ain.
(b) When t he asset is subject t o rapid obsolescence.
(c) When t he asset is required for immediat e use t o t ide over a t emporary problem
(d) all of t he above

8. In w hich of t he follow ing laese, t he lessee bears insurance, maint enance and repair cost s et c.
(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 equit y part icipant s and t he group borrow s a large
amount from financial inst it ut ions t o purchase t he leased asset . Such t ransact ion is called '
(a) Leveraged lease. (b) Operat ing Lease (c) Financial Lease (d) Sales-Aid Lease

10. A met hod of raising funds immediat ely required by lessee for w orking capit al or ot her purposes is:
(a) Operat ing Lease (b) Financial Lease (c) Sales-Aid Lease (d) Sales and Lease
back

11 . In short -t erm lease (operat ing lease) _______ is/ are safeguarded against t he risk of obsolescence
(a) Lessor (b) Lessee (c) Bot h (d) None of t he above

12. Which of t he follow ing are benefit s of Leasing:

(a) By employing 'sale and lease back' arrangement , t he lessee may overcome a financial crisis by immediat ely
arranging cash resources for some emergent applicat ion or for w orking capit al.
(b) Piecemeal financing of small equipment s is convenient ly possible t hrough lease arrangement only as debt
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financing for such it ems is impract icable.

(c) Tax benefit s may also somet imes accrue t o t he lessee depending upon his tax stat us.
(d) All of t he above

13. Which of t he above st at ement s are t rue?

(a) Lessor generally obt ain credit facilit ies from banks et c. t o purchase t he leased equipment w hich are subject
t o hypot hecat ion charge in favour of t he bank. Default in payment by t he lessor may somet imes result in seizure
of asset s by banks causing loss t o t he lessee.
(b) Lease financing has a very high cost of int erest as compared t o int erest charged on t erm loans by financial
inst it ut ions/ banks.
(c) Bot hof t he aabove
(d) Non of t he above

14. There are t hree met hods of evaluat ing a leasing proposal, w hich of t heses t hree are correct ?
(a) Present Value analysis (b) Int ernal Rat e of Ret urn analysis
(c) The Bow er Herringer Williamson met hod (d) All of t hese

15. In w hich of t he follow ing met hods, " t he present value of t he annual lease payment s (t ax adjust ed) is com-
pared w it h t hat of t he annual loan repayment s adjust ed for t ax shield on depreciat ion and int erest "
(a) Present Value analysis (b) Int ernal Rat e of Ret urn analysis
(c) The Bow er Herringer Williamson met hod (d) Account ing Rat e of ret urn met hod

16. Which met hod seeks t o est ablish t he rat e at w hich t he lease rent als, net of t ax shield on depreciat ion are
equal t o t he cost of leasing?
(a) Present Value analysis (b) Int ernal Rat e of Ret urn analysis
(c) The Bow er Herringer Williamson met hod (d) Account ing Rat e of ret urn met hod

17. Relat ed cash flow s can be discount ed bot h at w hich rat e

(a) Post Tax Cost of Debt (b) Cost of Capit al (c) None of t he above (d) Any of t he above

18. The various t ypes of Cash flow s involved in financing decisions are :
(a) Init ial Cash Out flow (b) Annual Cashflow (c) Terminal Cash flow (d) All of t he above

19. BELR means

(a) Break even lease rent als (b) Break even lease rat e
(b) Break even level of rent als forlessor (d) Break even level of rent als for lessee

20. The _________ involved is disposal/ salvage value of t he asset financed net of Tax Adjust ment 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 t he above

21. _______________ has been w idely used in some European count ries, t o arbit rage t he difference in t he t ax
law s of different count rie.
(a) Cross-border leasing (b) Financiaal Lease (c) Sales-Aid Lease (d) Sales and Lease
back
22. import ant object ives of cross border leasing include t he follow ing:
(a) The lessor can ut ilize very favourable " leveraged lease" financial account ing t reat ment for t he 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 follow ing a lessee default
because t he lessor is an ow ner and not a mere secured lender.
(c) Leasing provides t he lessee w it h 100% financing.
(d) All of t he above.

23. The principal players are

(a) one or more equit y invest ors;
(b) a special purpose vehicle formed t o acquire and ow n t he equipment and act as t he lessor;
(c) one or more lenders, and t he lessee.
(d) All of t he above

24. In order for t he lessor t o obt ain t he t ax benefit s associat ed w it h equipment leasing, most count ries require
t hat t he lease be t reat ed as a __________ for t ax 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 t o anot her, in cross border leasing most leasing st ruct ures are
essent ially similar and follow t he _________ pat t ern
(a) sale-leaseback (b) Operat ing Lease (c) Financiaal Lease (d) Sales-Aid Lease

26. As per Sect ion 45-IA of t he said Act , no non-banking financial company shall commence or carry on t he
business of a non-banking financial inst it ut ion w it hout :-
(a) obt aining a cert ificat e of regist rat ion issued under t his Chapt er; and
(b) having t he net ow ned fund of t w ent y-five lakh rupees or such ot her amount , not exceeding t w o hundred lakh
rupees, as t he RBI may, by not ificat ion in t he Official Gazette, specify
(c) Eit her (a) or (b)
(d) Bot h (a) and (b)

27. An Equipment Leasing Company has been an ______

(a) eligible NBFC (b) Not eligible NBFC

28. ______________ means any company w hich is a financial inst it ut ion carrying on as it s principal business, t he
act ivit y 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