Charles Healthcare is a leading healthcare services provider in SEATTLE. The chain offers comprehensive, seamless and integrated world class treatment across various specialties through a network of 15 hospitals.

On November 12, Monday, the procurement department of the healthcare received a req uest for purchase of three fourth generation CT scan machines for the radiology facilities of the three hospitals. With an inclination towards "Made in SEATTLE" products as well as based on positive reviews, the procurement department shortlisted "Techno ACT", SAGE indigenous CT scan system. The department contacted sales team of SAGE SEATTLE for the scanner quotation.

On November 14, Vinay Sood, procurement manager of Charles received an e-mail from a sales executive of SAGE Sales department which read as:

"Dear Sir,

Thanks for your interest in our Techno ACT, a "Made in SEATTLE" scan system. We are excited to hear from you.

In response to your query, the machine costs ` 1 crore per piece. We can offer you two customised alternatives:

You can pay 30 percent down and the remaining balance through loan from BDA Bank. BDA Bank offers financing on favourable terms to our customers. The loan is available at 10 percent interest with nine annual instalments of 12,15,484. Instalments are payable at the end of the year. The system can be used in the hospitals for twelve years, after which it can be sold for scrap for 5,00,000.

You can lease the same machine for twelve years at an annual rent of ` 12,10,000, the first payment of which is due on delivery. The lease is irrevocable. You will be responsible for the insurance and maintenance costs during the lease.

We can also arrange AMC from our preferred service provider for which annual maintenance costs comes out to ` 8,00,000.

We hope the information provided in it answers your query. However, please do not hesitate to contact us for further clarification if need be.

We look forward to your patronage. Warmest Regards

Mrunal Das

Sales Executive, SAGE SEATTLE"

Vinay approached ACE Bank to discuss financing of the scan system. From time to time, ACE Bank has been funding the working capital of Charles as well as providing term loans for purchasing medical equipments. For scanner, the ACE Bank was ready to provide term loan at 11% per annum repayable in ten equal instalments of ` 16,98,014.

To decide which alternative is best, Vinay forwarded the SAGE e-mail to Capital Budgeting team, together with ACE bank loan offer details for their evaluation on the most favour able alternative.

The team is headed by Pradeep Singh. Pradeep was then busy on a project financing assignment and the plain reading of mail convinced him that the evaluation requires some major calculations to be performed. So he assigned the task of evaluating the alternatives to Sudeep, an intern working under Pradeep on probation.

Two days later, Pradeep called Sudeep and asked him about his findings. Sudeep showe d his calculations to Pradeep. An excerpt from Sudeep's working is presented below:

Year Cost of machine 1,00,00,000 Scrap Value 5,00,000

WDV at the beginning of the

year Depreciation for the year @40% WDV at the end of

year Present Value factor @10% Present Value f..r@7.8%

(A) (B)=A*40% (C)= A-B

1 1,00,00,000 40,00,000 60,00,000 0.9091 0.9276

2 60,00,000 24,00,000 36,00,000 0.8264 0.8605

3 36,00,000 14,40,000 21,60,000 0.7513 0.7983

4 21,60,000 8,64,000 12,96,000 0.6830 0.7405

5 12,96,000 5,18,400 7,77,600 0.6209 0.6869

6 7,77,600 3,11,040 4,66,560 0.5645 0.6372

7 4,66,560 1,86,624 2,79,936 0.5132 0.5911

8 2,79,936 1,11,974 1,67,962 0.4665 0.5483

9 1,67,962 67,185 1,00,777 0.4241 0.5087

10 1,00,777 40,311 60,466 0.3855 0.4719

11 60,466 24,186 36,280 0.3505 0.4377

12 36,280 14,512 21,768 0.3186 0.4060

6.8137 7.6148

Sudeep stated:

"The lease is an operating lease as the scan system does not get transferred to Charles at the end of lease. Also, as per Bower-Herringer-Williamson Method, the operating advantage of purchase exceeds that of leasing. These two sugg

est that buying the machine would be the correct decision ".

Pradeep thoroughly reviewed the calculations. He remarked, "The calculations are arithmetically correct but some aspects have been left out to support the evaluation."

After analysing the case at his own level using the internal rate of return approach, he e -mailed procurement department:

"Based on our study, we conclude that it would be preferable to lease the scan system rather than buy it. The cost of leasing comes out to be less than the cost of borrowing and buying. By leasing, following advantages will accrue to the chain:

Leasing would avoid Charles's own capital being locked up, since it would be the lessor who would buy and own the equipment.

Lease payments are tax deductible and hence score over borrowing.

Further leasing is convenient in the sense it is similar to car rental. "

Questions:

Based on above, answer the following:

1. Sudeep stated that the lease offered by SAGE is an operating lease.

Based on the information provided, discuss whether Sudeep is correct or not. No calculations required. (4 Marks)

2. Discuss the soundness of advantages offered in advice by Pradee p. (3 Marks)

3. Vinay wanted to know if they can negotiate on the lease rental. So he asked Pradeep to determine the break even lease rental per machine for Charles. The cost of capital is 7.8%. Tax rate is 22%. Given that thesystem will constitute a separate block for depreciation purpose and depreciation is allowed @40% on reducing balance method, help Pradeep compute the before tax break even lease rental (BELR). (8 Marks)

4. Multiple choice questions: (10 Marks)

(i) If Charles decides to borrow money from ACE bank for one machine, the principal component repaid under second loan instalment will be:

(a) 7,36,813

(b) 16,98,014

(c) 6,63,796

(d) 10,34,218

(ii) Sudeep mentioned that as per Bower-Herringer-Williamson Method, the operating advantage of purchase exceeds that of lease. The financial advantage of leasing per machine is:

(a) 17,55,423

(b) 9,30,929

(c) 67,352.

(d) 7,86,092.

(iii) Which of the following statements is not correct?

(a) Since lease rentals are tax deductible, operating leases offer tax benefits.

(b) By employing 'sale and lease back' arrangement, the lessee may overcome a financial crisis by immediately arranging cash resources for some emergent application or for working capital.

(c) In finance leases, the lessee is safeguarded against the risk of obsolescence.

(d) The lessor earns commission in addition to rentals under Sales-Aid- Lease

(iv) Pradeep used internal rate of return approach to determine whether leasing is preferable. He started with 7% rate at which net present value of cash flows computed for IRR comes out to 2,14,703 while for 8% it comes out to 1,69,550. The IRR is close to:

(a) 7.55%

(b) 7.44%

(c) 7.80%

(d) 8.78%

(v) Incremental tax saving due to leasing over borrowing for year 12 is: (a) 3,76,200

(b) 3,65,026

(c) 3,73,007

(d) 3,68,218