2.4. Replacement and Lease Decisions
INTRODUCTION :
‘When to replace individual units of durable equipment by similar or improved units is one of the
main problems upon which the success of industrial enterprise depends.’ –Gabriel Preinreich
For the past 50 years, mass production of goods and services by the manufacturing and
process industries has proved to be a most efficient means of satisfying human wants and
needs. To achieve these ends, however, industry has shown a high propensity of consume
vast quantities of capital resources, either due to physical impairment or because of the
inevitable obsolescence experienced by capital assets. To remain competitive, therefore,
necessiates the timely replacement of existing assets and their eventual retirement.
MEANING : The term ‘replacement’ can be rather ambiguous. Replacement does not mean
that an asset has to be duplicated at the end of its economic life, nor does it imply a like-forlike
substitution indeed no resemblance betwen the present asset and its successor is necessary.
Instead, ‘replacement’ in this context is synonymous with ‘displacement’, which simply
means that an existing asset is displaced by a more economic one. This implies that the end
product or service involved with a replacement decision remains the same, but the means
(process, methods, systems, machines and tools) of accomplishing that objective can alter
quite radically.
The term ‘retirement’ means that an asset is definitely disposed of. In some instances this
might entail selling a group of assets as a going concern, in which case one is really conccerned
with divestment decisions. In other circumstances, however, assets are sold for their secondhand
or scrap value. In some extreme condiions it is also conceivable that a company might
have to spend money to dispose of certain assets, either because of some contractual agreement
which was involved with their initial purchase, or because their disposal has certain
social and/or legal implications.
BASIC REASONS FOR REPLACEMENT/RETIRING OF ASSET: – The two basic reasons
for replacing and ultimately retiring an asset are (a) physical impairment and (b) technological
obsolescence.
The first involves the condition of the asset itself, whereas the second concerns conditions in
the environment which are external to an asset. These two effects can occur independently,
or in concert.
Physical impairment : Physical deterioration can lead to a loss in the value of the service
rendered by an asset and /or an increase in its consumption of resources needed to
provide a pescribed level of service. For example, corrosion, erosion and general wear
and tear can prevent a machine from manufacturing its specified output of product
thereby causing its sales revenue to decline, whereas a specified production rate might
possibly be attained if more monies were spent on its ordinary repairs and maintenance.
This Section includes :
• Meaning of Replacement and Retirement
• Reasons of Replacement / Retirement
• Lease Reutal Alternatives
• Buy or Lease
Technological obsolescence : Obsolescence, however, is the change in the technical
characteristics of new assets which enhances their vaue relative to older assets and it
results from product, labour and process innovations. More often than not, this rate of
enhancement is sufficiently large to warrant the replacement of existing assets which
are still in good physical condition and profitable. In other cases, however, replacement
is justified because a decline in a firm’s sales renders its existing production capacity too
large and expensive so that it is forced to retrench, at least temporarily, using smaller
plant employing the same or more efficient technology.
Company X needs a machine which if purchased outright will cost Rs. 10 lakhs. A Hire
Purchase and Leasing Company has offered two alternatives as below :
Option II [Amount in Rs.]
1 2 3 4 5 6 7 8
Year Rentals Monthly PV of (2) Tax Annual PV of (5) Net Cash
Dis. Factor Shield Disc. Fac- Flow (4-7)
@ 15% (2)×40% tor @ 15%
0 22500 1.000 22500 — — — 22500
1 63000 0.923 58149 25200 0.869 21899 36250
2 63000 0.795 50085 25200 0.756 19051 31034
3 63000 0.685 43155 25200 0.658 16582 26573
4 63000 0.590 37170 25200 0.572 14414 22756
5 63000 0.509 32067 25200 0.497 12524 19543
6 — 0 5625* 0.432 2430 -2430
7 — 0 4219* 0.376 1586 -1586
8 — 0 3164* 0.327 1035 -1035
Terminal Depn. 0 9492* 0.284 2696 -2696
150909
*Since the lession is selling asset to lessee at the end of 5 years against deposit of 15% of
Rs. 150000 i.e. Rs. 22,500, Lesee becomes the owner and starts claiming tax benefit on
depreciation for the next three years. (assumed to be WDV at 25%)
Depreciation schedule :
Year Orignal Cost Depreciation Outstanding
Rs. Rs.
1 22500 5625 16875
2 16875 4219 12656
3 12656 3164 9492
4 9492 9492 0
Advice :
Analyzing these table it is concluded that :
Since the net effective cost of Option II is the least, it is advisable to choose the same.
Fianancial Management & international finance 179
1 2 3 4 5 6 7 8
Year Principal Interest Depreciation Tax Shield Tax Shield Incremental Discounted
@ 16% p.a. SLM (3+4)×50% On Leasing tax saving due cash flow
to leasing @ 15%
0 89127 — — — — — —
1 89127 65740* 50000 57870 36988# (20882) (18167)
2 89127 61998 50000 55999 36988 (19011) (14448)
3 89127 57657 50000 53829 36988 (16841) (11115)
4 89127 52622 50000 51311 36988 (14323) (8164)
5 89127 46781 50000 48391 36988 (11403) (5702)
6 89127 40006 50000 45003 36988 (8015) (3446)
7 89127 32146 50000 41073 36988 (4085) (1552)
8 89127 23029 50000 36515 36988 473 145
9 90290 12454 50000 31227 36988 5761 1613
10 50000 25000 36988 11988 2997
TOTAL (57828)
* Interest in Principal. Since paid in advnce, 89125 will get subtracted from 50000 and interest
will be calculated on that amount.
# Tax shield on Lease Rental = 0.5*73976 = 36988
Since, If Fa + OA, > go for Leasing
Option : Hire Purchase
Rs. 2,50,000 will be payable on singing of the agreement. 3 annual installements of Rs.
4,00,000 will be payable at the end of the year starting from year 1. The ownership in the
machine will be transferred automatically at the end of the 3rd year. It is assumed that
Company X will be able to claim depreciation on straight line basis with zero salvage value.
Option : Lease
Rs. 20,000 will be payable towards initial service fee upon singing of the agreement. Annual
lease rent of Rs. 4,32,000 is payable at the end of each year starting from the first, for a period
of 3 years.
Company X’s tax rate is 35%.
Evaluate the two alternatives and advice the Company as to which one implies least cost.
Solution :
Option A : Hire Purchase
Calculation of Finance Charges
180 Fianancial Management & international finance
End of the year HP Installments Finance Charges Cash Price
Rs. Rs. Rs.
0 250000 — 250000
1 400000 225000 175000
2 400000 150000 250000
3 400000 75000 325000
1450000 450000 1000000
** The Total Charges allocated in the rti of HP Price outstanding i.e. 3:2:1
Calculation of Annual Depreciation : Rs. 1000000/3 = Rs. 333333
Calculation of Cash Outflow :
End of the year HP Installments Tax Shield @35% Net Outflow
on Fin. Charges + Depreciation
Rs. Rs. Rs.
0 250000 — 250000
1 400000 195417 204583
2 400000 195417 230833
3 400000 142917 257083
Calculation of Present Values
End of the Year PVF @ 10% PV PVF @ 20% PV
0 1.00 250000 1.00 250000
1 0.91 186171 0.83 169804
2 0.83 191591 0.69 159275
3 0.75 192812 0.58 149108
Total 820574 728184
The net cash outflows when disconted at 20% comes down by Rs. 92387 (i.e. 820574–728187).
The effective cost of finance, is found out by calculating the rate at which the present values
equal Rs. 650000 (i.e. Rs. 1000000×0.35) (i.e. cost of asset×(1-t) ).
Effective cost of finance = % 10 28.46%
92387
170574
10 = ⎟⎠
⎞ ⎜⎝⎛ × +
Option B : Leasing
Cash Flows :
End of the Year Lease Charges Tax Shield @ 35% Net Outflow
Rs. Rs. Rs.
0 20000 — 20000
1 432000 152800 273800
2 432000 151200 280800
3 432000 151200 280800
Fianancial Management & international finance 181
Calculation of Present Values
End of the Year PVF @ 10% PV PVF @20% PV
0 1.00 20000 1.00 20000
1 0.91 249158 0.83 227254
2 0.83 233064 0.69 193752
3 0.75 233064 0.58 162864
TOTAL 735286 603870
The net cash outflows when discounted at 20% comes doen by Rs. 131416 (i.e. 735286–
603870). The effective cost of financing under the lease option is calculated below :
Effective cost financing % 10 16.49%
131416
85286
10 = ⎟⎠
⎞ ⎜⎝
= + ⎛ ×
Calculation : Option B, i.e. lease option implies lesat cost.
LEASE RENTAL ALTERNATIVES :
LEASE FINANCING
Concept of Leasing:
Leasing, as a financing concept, is an arrangement between two parties, the leasing company
or lessor and the user or lessee, whereby the former arranges to buy capital equipment
for the use of the latter for an agreed period to time in return for the payment of rent. The
rentals are predetermined and payable at fixed intervals of time, according to the mutual
convenience of both the parties. However, the lessor remains the owner of the equipment
over the primary period.
By resorting to leasing, the lessee company is able to exploit the economic value of the equipment
by using it as if he owned it without having to pay for its capital cost. Lease rentals can
be conveniently paid over the lease period out of profits earned from the use of the equipment
and the rent is cent percent tax deductible.
I. Lease is defined as follows:
• Dictionary of Business and Management –
‘Lease is a form of contract transferring the use or occupancy of land, space, structure
or equipment, in consideration of a payment, usually in the form of a rent.’
• James C. Van Horne –
‘Lease is a contract whereby the owner of an asset (lessor) grants to another party
(lessee) the exclusive right to use the asset usually for an agreed period of time in
return for the payment of rent.
II. TYPES OF LEASING:
Finance Lease and Operating Lease:
Finance Lease: According to the International Accounting Standards (IAS-17), in a
finance lease, the lessor transfers to the lessee substantially all the risks and rewards
incidental to the ownership of the asset whether or not the title is eventually transferred.
It involves payment of rentals over an obligatory non-cancellable lease period,
sufficient in total to amortise the capital outlay of the lessor and leave some profit. In
such leases, the lessor is only a financier and is usually not interested in the assets. It is
for this reason that such leases are also called as full payout leases as they enable a
lessor to recover his investment in the lease and earn a profit. Types of assets included
under such lease are ships, aircrafts, railway wagons, lands, buildings, heavy machinery,
diesel generating sets and so on.
Operating Lease : According to the IAS-17, an operating lease is one which is not a
finance lease. In an operating lease, the lessor does not transfer all the risks and rewards
incidental to the ownership of the asset and the cost of the asset is not fully
amortised during the primary lease period. The lessor provides services (other than
the financing of the purchase price) attached to the leased asset, such as maintenance,
repair and technical advice. For this reason, operating lease is also called Service lease.
The lease rentals in an operating lease include a cost for the ‘services’ provided, and
the lessor does not depend on a single lessee for recovery of his cost. Operating lease is
generally used for computers, office equipments, automobiles, trucks, some other equipments,
telephones, and so on.
Direct Lease : In direct lease, the lessee, and the owner of the equipment are two
different entities. A direct lease can be of two types: Bipartite and Tripartite lease.
Bipartite Lease : There are two parties in the lease transaction: (1) equipment supplier-
cum-lessor and (ii) lessee. Such type of lease is typically structured as an operating
lease with inbuilt facilities, like upgradation of the equipment (Upgrade lease),
addition to the original equipment configuration and so on. The lessor maintains the
asset and, if necessary, replaces it with a similar equipment in working conditions
(Swap lease).
Tripartite Lease : Such type of lease involves three different parties in the lease agreement:
equipment supplier, lesssor and lessee. An innovative variant of tripartite lease
is the sales-aid lease under which the equipment supplier arranges for lease finance in
various forms by:
• Providing reference about the customer to the leasing company;
• Negotiating the terms of the lease with the customer and completing all the
formalities on behalf of the leasing company;
• Writing the lease on his own account and discounting the lease receivables with
the designated leasing company.
The sales-aid lease is usually with recourse to the supplier in the event of default by the lessee
either in the form of offer from the supplier to buy back the equipment from the lessor or a
guarantee on behalf of the lessee.
Single Investor Lease and Leveraged Lease
Single Investor Lease : There are only two parties to the lease transaction, the lessor and the
lessee. The leasing company (lessor) funds the entire investment by an appropriate mix of
debt and equity funds. The debts raised by the leasing company to finance the asset are
Fianancial Management & international finance 183
without recourse to the lessee, that is, in the case of default in servicing the debt by the
leasing company, the lender is not entitled to payment from the lessee.
Leveraged Lease : There are three parties to the transaction: (1) lessor (equity investor), (2)
lender and (3) lessee. In such a lease, the leasing company (equity investor) buys the asset
through substantial borrowing with full recourse to the lessee and without any recourse to
itself. The lender (loan participant) obtains an assignment of the lease and the rentals to be
paid by the lessee are a first mortgaged asset on the leased asset. The transaction is routed
through a trustee who looks after the interest of the lender and lessor. On receipt of the
rentals from the lessee, the trustee remits the debt-service component of the rental to the loan
participant and the balance to the lessor.
Domestic Lease and International Lease :
Domestic Lease : A lease transaction is classified as domestic if all parties to the agreement,
namely, equipment supplier, lessor and the lessee, are domiciled in the same country.
International Lease : If the parties to the lease transaction are domiciled in different countries,
it is known as international lease. This type of lease is further subclassified into import
lease and cross-border lease.
Import Lease : In an import lease, the lessor and the lessee are domiciled in the same country
but the equipment supplier is located in a different country. The lessor imports the asset and
leases it to the lessee.
Cross-Border Lease : When the lessor and the lessee are domiciled in different countries,
the lease is classified as cross-border lease. The domicile of the supplier is immaterial.
Sale and Lease Back :
Under both the direct lease and the leveraged lease, the lessee acquires the asset after the
lease arrangement. However, in case of sale and lease back, the situation is different. The
lessee is already the owner of the assets. He, under the lease agreement, sells the assets to the
lessor who, in turn, leases the assets back to the owner (now the lessee). Under the sale and
lease back, the lessee not only retains the use of the assets but also gets funds from the ‘sale’
of the assets to the lessor. The sale and lease back is usually preferred by firms having fixed
assets but shortage of funds. The Figure depicts the mechanism of sale and lease back.
FORMS OF LEASE RENTALS:
The lease rentals may be quoted in several forms, for instance
i) Level or constant period
ii) Stepped where the lease rental increases at a fixed percentage over the earlier period,
iii) Deferred, where the rental is deferred for certain periods to accommodate gestation
period,
iv) Ballooned under which major part of the rentals is collected in a lump sum at the end
of the primary period,
v) Bell – shaped where the rental is gradually stepped up, rises to its peak in the middle
of the lease period and is then gradually stepped down and
vi) Zig-zag where the rental is stepped up in one period and then stepped down in the
succeeding period and so on.
Illustration 1 :
A company has received 3 proposals for the acquisition of an assets on lease costing
Rs. 1,50,000.
Option I : The terms of offer envisaged payment of lease rentals for 96 months. During the
first 72 months, the lease rentals were to be paid @ Rs. 30 p.m. per Rs. 1,000 and during the
reamining 24 months @ Rs. 5 p.m. per Rs. 1,000. At the expiry of lease period, the lessor has
offered to sale the assets at 5% of the original cost.
Option II : Lease agreement for a period of 72 months during whcih lease rentals to be paid
per month per Rs. 1,000 are Rs. 35, Rs. 30, Rs. 26, Rs. 24, Rs. 22 and Rs. 20 for next 6 years.
At the end of lease period the asset is proposed to be abandoned.
Option III : Under this offer a lease agreement is proposed to be signed for a period of 60
months wherein a initial lease deposit to the extent of 15% will be made at the time of signing
of agreement. Lease rentals @ Rs. 35 per Rs. 1,000 per months will have to be paid for a
period of 60 months on the expiry of leasing agreement, the assets shall be sold against the
initial deposit and the asset is expected to last for a further period of three years.
You are requred to evaluate the proposals keeping in view the following parameters.
(i) Depreciation @ 25%
(ii) Discounting rate @ 15%
(iii) Tax rate applicable @ 40%
The monthly and yearly discounting factors @ 15% discount rate are as follows :
Period 1 2 3 4 5 6 7 8
Monthly 0.923 0.765 0.685 0.590 0.509 0.438 0.377 0.325
Yearly 0.869 0.756 0.658 0.572 0.497 0.432 0.376 0.327
Solution :
Given below are the three tables showing the calculations to decide the best option.
Fianancial Management & international finance 185
Option I [Amount in Rs.]
1 2 3 4 5 6 7 8
Year Rentals Monthly PV of (2) Tax Annual PV of (5) Net Cash
Dis. Factor Shield Disc. Fac- Flow (4-7)
@ 15% (2)×40% tor @ 15%
1 54000 0.923 49842 21600 0.869 18770 31072
2 54000 0.795 42930 21600 0.756 16330 26600
3 54000 0.685 36990 21600 0.658 14213 22777
4 54000 0.590 31860 21600 0.572 12355 19505
5 54000 0.509 27486 21600 0.497 10735 16751
6 54000 0.438 23652 21600 0.432 9331 14321
7 9000 0.377 3393 3600 0.376 1354 2039
8 9000 0.325 2925 3600 0.327 1177 1748
End 7500 0.327 2452 — 2452
0.327 is Year ending discounting factor 137265
Option II [Amount in Rs.]
1 2 3 4 5 6 7 8
Year Rentals Monthly PV of (2) Tax Annual PV of (5) Net Cash
Dis. Factor Shield Disc. Fac- Flow (4-7)
@ 15% (2)×40% tor @ 15%
1 63000 0.923 58149 25200 0.869 21899 36250
2 54000 0.765 42930 21600 0.756 16330 26600
3 46900 0.685 32058 18720 0.658 12318 19740
4 43200 0.590 25488 17280 0.572 9884 15604
5 39600 0.509 20156 15840 0.497 7872 12284
6 36000 0.438 15768 14400 0.432 6221 9547
120025
Comments (0)
Post a Comment