TAX PLANNING AND SPECIFIC MANAGEMENT DECISION - mfc 2021 081021.pptx

Describes the tax planning techniques

1. TAX PLANNING WITH REFERENCE TO LEASE V/S PURCHASE A lease of property is a transfer of right to enjoy such property, made a certain time, in consideration of a price payable periodically to the transferor by the transferee. In other words, leasing is an arrangement that provides a person with use & control over an asset, for a price payable periodically, without having a title of ownership. In case of lease agreement the owner of the asset is called the lessor & the user is called the lessee. When a person needs an asset for his business purpose, he has to decide whether the asset should be purchased / taken on lease.

2. TAX PLANNING WITH REFERENCE TO LEASE V/S PURCHASE Advantages when Assets are taken on Lease : Lease Rental can be claimed as deduction as revenue expenditure. However Depreciation cannot be claimed since assets are not owned by the assessee. Advantage when Assets are Purchased : Depreciation on specified assets can be claimed as deduction u/s 32. The Assets may be purchased out rightly or may be taken on loan. Where the asset is taken on loan interest amount can either be claimed as revenue expenditure . Note : Since the lease rentals and loan are repayable in instalments, then the cash outflow for each separate year should be converted into present value of today’s cost.

3. HOW TO SOLVE QUESTIONS Where the Asset is Leased : Compute the processing fees in year in which it is payable. Compute Lease Rental spread over a number of years. Compute Cash Outflow (processing fees + lease rental) spread over a number of years. Compute Tax saved on deduction claimed ( processing fees + lease rental) spread over a number of years. Compute adjusted cash Outflow which is ( 3 – 4 ) Compute present value of adjusted cash outflow.

4. BUY V/S LEASE Q. An assessee, who carries on a business, acquires a machinery costing Rs.1,00,000. This machinery has a life of 5 years. Decide which one is a better alternative – buy or lease – in the following situation: The Rate of Depreciation is 15%. Tax Rate: 30.9% Cost of Capital: 14% In case , the machinery is taken on LEASE : Lease Cost: Rs.34000 per annum for 5 years. PVF table is given below @ 14% for next 5 years. Year 1 Year 2 Year 3 Year 4 Year 5 0.877 0.769 0.675 0.592 0.519

5. EVALUATION OF DECISION TO BUY Year Amount of Depreciation @ 15% (WDV) Tax Saving on Depreciation PVF @ 14% Present Worth of Tax Savings 1 15000 4635 0.877 4065 2 12750 3940 0.769 3030 3 10838 3349 0.675 2261 4 9212 2847 0.592 1685 5 7830 2419 0.519 1255 12296 Working Notes : Tax Saving on Depreciation = Amount of Depreciation * Tax Rate of 30.9% Present Worth of Tax Savings = Tax Saving on Depreciation * PVF @ 14%

6. EVALUATION OF DECISION TO BUY Calculation of Net Cash Outflow Cash Outflow on account of purchase of machinery 1,00,000 Less: Present Value of Tax Savings on account of Depreciation (12,296) = Net Cash Outflow 87,704

7. EVALUATION OF DECISION TO LEASE Year Lease Rental Tax Saving on Lease Rental Differential Cash Outflow PVF @ 14% Present Value of Differential Cash Outflow 1 34000 10506 23494 0.877 20604 2 34000 10506 23494 0.769 18067 3 34000 10506 23494 0.675 15858 4 34000 10506 23494 0.592 13908 5 34000 10506 23494 0.519 12193 80,630 Working Notes: Tax Saving on Lease Rental = Amount of Lease Rental * Tax Rate of 30.9% Differential Cash Outflow = Lease Rental – Tax Saving on Lease Rental Present Value of Differential Cash Outflow = Differential Cash Outflow * PVF @ 14%

8. FINAL DECISION As the Net Cash Outflow in the case of Lease (Rs.80,630) is less as compared to the Net Cash Outflow in case of Buy (Rs.87,704) , the company should go for taking the machinery on LEASE.

9. HOW TO SOLVE QUESTIONS Where the Asset is Purchased on Loan : Compute Repayment of Loan spread over a number of years. Compute Interest on Loan spread over a number of years. Compute each Outflow ( Interest + repayment of Loan) spread over a number of years. Compute Depreciation on Assets spread over a number of years. Compute Tax saved on deduction claimed ( Interest + depreciation) spread over a number of years. Compute adjusted cash outflow which is ( 3 – 5 ) Compute present value of adjusted cash outflow.

10. LOAN V/S LEASE Q. R Ltd., a manufacturing company needs a generator for its activities. The cost is Rs.1,00,000. On making enquiries, it is learnt that the company has two options. Option 1: Buying the asset by taking a loan of Rs.1,00,000 repayable in five equal instalments of Rs.20,000 each along with interest @ 12% p.a. Option 2: Leasing the asset for which annual lease rental is Rs.30,000 up to 5 years. The lessor charges 1% processing fees in first year. As the Tax Manager advise the company management on which option should be selected. Additional Information : 🞭 Tax rate applicable to the company is 30.9%. 🞭 The Depreciation Rate is 15% (plus additional depreciation : 20%). 🞭 Assuming internal rate of return 10% for present value factor. PVF Table is given below @ 10% for next 5 years. Year 1 Year 2 Year 3 Year 4 Year 5 0.909 0.826 0.751 0.683 0.621

11. EVALUATION OF DECISION TO TAKE LOAN Calculation of Gross Cash Outflows on account of Loan Year Loan Repayment (Instalment) Principal amount in the beginning of the year Interest @ 12% Gross Cash Outflow 1 20000 100000 12000 32000 2 20000 80000 9600 29600 3 20000 60000 7200 27200 4 20000 40000 4800 24800 5 20000 20000 2400 22400 Gross Cash Outflow = Loan Repayment ( Instalment Amount) + Interest Amount

12. EVALUATION OF DECISION TO TAKE LOAN Calculation of Present Value of Net Cash Outflows Year Gross Outflow Depreciation (1) Interest (2) Tax Savings on (1)+(2) Net Outflow PVF @ 10% Present Value of Net Outflow 1 32000 35000 12000 14523 17477 0.909 15887 2 29600 9750 9600 5979 23621 0.826 19511 3 27200 8288 7200 4786 22414 0.751 16833 4 24800 7044 4800 3660 21140 0.683 14439 5 22400 5988 2400 2592 19808 0.621 12301 78,971 Total Present Value of Net Cash Outflows= Rs. 78,971

13. EVALUATION OF DECISION TO TAKE LOAN Working Notes: Tax Savings = Tax Rate(30.9%) * {Depreciation + Interest Amount} Net Outflow = Gross Outflow – Tax Savings Present Value of Net Outflow = Net Outflow * PVF @ 10%

14. EVALUATION OF DECISION TO TAKE LEASE Year Lease Rental Processing Fees Gross Outflow Tax Saving Net Cash Outflow PVF @ 10% Present Value of Net Cash Outflow 1 30000 1000 31000 9579 21421 0.909 19472 2 30000 - 30000 9270 20730 0.826 17123 3 30000 - 30000 9270 20730 0.751 15568 4 30000 - 30000 9270 20730 0.683 14159 5 30000 - 30000 9270 20730 0.621 12873 79,195

15. FINAL DECISION As the Net Cash Outflow in the case of Loan (Rs.78,971) is less as compared to the Net Cash Outflow in case of Lease (Rs.79,195) , the company should take the asset on a LOAN.

16. SPECIFIC MANAGEMENT DECISION 🞭 CAPITAL MIX :- A capital structure is said to be optimum when it has a mix of debt and equity that will yield the lowest possible weighted average cost of capital to the company or gets maximum return on equity share capital. 🞭 At the same time the capital mix should not have high debt equity ratio.

17. CAPITAL MIX 🞭 Q.) An Indian company is considering three different proposals of raising Rs. 1200000 for a project where earning before tax estimated as 36% of the capital employed. The company can raise this entire amount either by issue of equity share entirely or combination along with borrowing from a bank @12% p.a. or by issuing of debentures and any capital mix of three sources, which of the following three alternatives should it opt for: Entire Rs. 1200000 to be raised through equity share capital Rs. 600000 from equity shares and Rs. 300000 from each other sources available. Rs. 400000 from each source available. Assume the company shall distribute the entire amount of profits as dividend and applicable corporate tax rate is 30.9%. What will be your answer, if return on capital employed before tax is 12% instead of 36%, other things reaming the same?

18. SOLUTION- PARTICULARS ALTERNATIVE A B C EQUITY SHARE CAPITAL 1200000 600000 400000 LOAN FROM BANK@12% - 300000 400000 DEBENTURES ISSUED @14% - 300000 400000 TOTAL INVESTMENT 1200000 1200000 1200000 EBIT(@ 36% OF CAPITAL EMPLOYED) 432000 432000 432000 LESS:- interest on loan @ 12% - 36000 48000 LESS:- interest on debenture @ 14% - 42000 56000 Earning Before Tax 432000 354000 328000 LESS:- Tax @ 30.9% 133488 109386 101352

19. SOLUTION- PARTICULARS ALTERNATIVES A B C EARNINGS AFTER TAX(1) 298510 244610 226648 TAX ON DIVIDEND TO BE DISTRIBUTED@ 17.65% (2) 52687 43174 40003 AMOUNT OF DIVIDEND DISRTIBUTED (1-2) 245823 201436 186645 RETURN ON EQUITY SHARE CAPITAL 20.48% 33.57% 46.66% *

20. DECISION- 🞭 As the return on equity employed is highest (46.66%) in ALTERNATIVE C i.e. Rs. 400000 from each source namely, equity, debentures and loan from bank is the best alternative and company should go for it.

21. IF RETURN ON CAPITAL EMPLOYED IS 12%? PARTICULARS ALTERNATIVES A B C EBIT(12% OF CAPITAL EMPLOYED) 144000 144000 144000 LESS:- INTEREST ON LOAN @12% - 36000 48000 LESS:- INTEREST ON DEBENTURES@ 14% - 42000 56000 EBT 144000 66000 40000 LESS:- TAX@ 30.9% 44496 20394 12360 EAT 99504 45606 27640 LESS:- TAX ON DIVIDEND @17.65% 17562 8050 4878 AMOUNT OF DIVIDEND DISTRIBUTED 81942 37556 22762 RETURN ON EQUITY SHARE CAPITAL 6.82% * 5.92% 5.69%

22. DECISION:- 🞭 As the return on equity employed is highest (6.82%) in ALTERNATIVE A i.e. entire Rs.1200000 raised from issue of equity shares, it is the best alternative and company should go for it.