In case of capital investment decision, the company management will consider two alternatives: (a) whether the asset should be purchased or (b) it should be leased. For the decision-making purpose, the total cost of the two alternatives will be compared to know the additional savings. If there is a savings on purchase, then it should be considered and vice-versa.
Illustration
ABC Ltd., is having two alternatives to acquire a godown. Either the company can purchase the godown for Rs.8,80,000 or acquire it on lease for an annual rent of Rs.88,000. If the godown is purchased, then the land will cost Rs.88,000 and renovation will be Rs.1,32,000. If the company takes the godown on lease, it has to pay the insurance charges and tax. The insurance charge will be 1.1% to be computed on the value before renovation and it will be constant after that. The tax on property is Rs.26,400. Repairs and maintenance to the property will be Rs.26,400. The estimated life of the godown is 20 years and depreciation is charged at straight-line method. The amount required to purchase the godown will yield 8% tax exempted interest if invested in securities. Advise the management and help it to decide whether to lease or purchase.
Solution
Statement Showing the Annual Operating Cost for Two Alternatives
|
Particulars
|
Purchase
|
Lease
|
|
Property Tax/Repairs
|
26,400
|
26,400
|
|
Insurance 1.1 % on 7,92,000
|
8,712
|
8,712
|
|
Depreciation
(7,92,000 + 1,32,000)/20
|
46,200
|
-
|
|
Lease rent
|
-
|
88,000
|
|
Total cost
|
81,312
|
1,23,112
|
|
Interest (opportunity cost)
8,80,000 + 1,32,000 @ 8%
|
80,960
|
|
|
Total cost + opportunity cost
|
1,62,272
|
1,23,112
|
From the above analysis it is clear that the firm should go for leasing of the godown. The company can invest its money in marketable securities and get the interest income that tax-free.
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