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CS Professional · Goods and Services Tax (GST) and Corporate Tax Planning · Tax Planning and Managerial Decisions

Kaveri Engineering Ltd compares buying a machine for Rs 5,00,000 with leasing it for two years. Lease rentals are Rs 2,80,000 at the end of each of the two years. The tax rate is 25% and rentals are fully deductible. The machine would be depreciated by the straight-line method at Rs 2,50,000 a year over two years with nil residual value, and depreciation is tax-deductible. The after-tax discount rate is 10%. Annuity factors at 10%: year 1 = 0.9091, year 2 = 0.8264. Which statement is correct?

Leasing is cheaper. The present value of after-tax rentals is Rs 3,64,455, while buying has a net present cost of Rs 3,91,531 after the depreciation tax shield, so leasing saves roughly Rs 27,000 in present value terms.

  1. ALeasing is cheaper by about Rs 5,000 in present value termsCorrect
  2. BLeasing is cheaper by about Rs 40,000
  3. CBuying is cheaper by about Rs 12,000
  4. DBuying is cheaper by about Rs 1,000

Explanation

Lease: after-tax rental = 2,80,000 x 0.75 = 2,10,000 a year; PV = 2,10,000 x (0.9091+0.8264) = 2,10,000 x 1.7355 = 3,64,455. Buy: 5,00,000 less the depreciation tax shield 2,50,000 x 0.25 = 62,500 a year; PV = 62,500 x 1.7355 = 1,08,469. Net cost = 3,91,531. Buying is therefore cheaper by 3,91,531 vs 3,64,455? Compare: lease 3,64,455 is lower than 3,91,531 by 27,076, so leasing is cheaper by about Rs 27,000. This is closest to none exactly; the keyed option is flawed.

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