Lease Financing

What is Lease?

Leasing is a Financial arrangement, under which owner of the asset (Lessor) allows the user of the asset (Lessee) to use the asset for a Specified Period of Time (Lease Term) for periodic Consideration (Lease Rent).

It is a contract where one party purchases the asset and permits its use by another party over a specified period of time. It is an alternative to purchase an asset.

  1. Leases are the legal and binding contracts that set forth the terms of rental agreements in real estate.
  2. If a person wishes to rent an apartment or other residential property, for example, the lease prepared by the landlord describes the monthly rent amount, when it is due each month, what happens if the lessee fails to pay his rent, how much of a security deposit is required, the duration of the lease, whether the lessee is allowed to keep pets on the premises, how many occupants can live in the unit and any other essential information.
  3. The landlord requires the tenant to sign the lease, thereby agreeing to its terms before occupying the property.

Parties involved in Leasing:

Lessor:  He is the real owner of the asset and gives permission to use the asset to another party. As a result of this, Lessor receives Lease Rent, which is taxable in the hands of Lessor.

Lessee: He avails the benefit of usage of Machine, though he is not the real owner of the asset. He pays Lease Rent for the usage of asset.

Classification of Leasing

Financial Lease

Finance Lease is an arrangement to Finance the use of equipment to for major part of its useful life. It is a Loan in disguise, so it is also called as Capital Lease.

It has longer term as it includes major life of the asset. Lessor is only the Legal Owner, all the risks and rewards incident to ownership are passed on to Lessee. Lessee also bears the Risk of Obsolescence (Depreciation).

This agreement cannot be cancelled by either party. Lessor does not bear the cost of repairs, maintenance etc.  He only acts as Financier. The Lease is usually Full Pay out.  Single Lease repays Cost of Asset and Interest.

Variants of Finance Lease:

  1. Lease with Purchase Option – Lessee has the right to purchase the Leased Assets after the expiry of Initial Lease period at an agreed price
  2. Lease with Lessee having Residual Benefits – Lessee has the right to share the sale proceeds of the asset after the expiry of Initial Lease Period and/or to renew the lease agreement at a lower rate.

Operating Lease

If the Lease does not secure for the Lessor the recovery of Capital Outlay plus a return on the funds invested, during the lease term. The Term of Operating Lease is shorter than that of Asset’s Useful Life.

Risk Incident to Ownership wholly belongs to Lessor. Depreciation is borne by Lessor.

The Lease can be cancellable by Lessor.

Lessor bears the Cost of Repairs pertaining to asset as lease is only for shorter period.

The Lease is usually Non Pay out, as lessor expects to lease the asset again and again.

Difference between Operating Lease and Financial Lease

Operating Lease Financial Lease
Lessor allows lessee to use the Asset for a term smaller than the Useful Economic Life of Asset Lessor allows lessee to use the Asset for maximum part of term of Useful life of Asset
Risk incident to Ownership remains  with lessor Lessor is only the Legal Owner

Risk associated with Ownership are transferred to Lessee

All Risks are borne by Lessor All Risks are borne by Lessee
Lease Agreement is Cancellable by Lessor Lease Agreement is Non-Cancellable by either parties
Lessor bears all costs associated with the Asset Lessor only acts as a Financier

He does not bear any Costs

Advantages and Disadvantages in a Lease Proposal to Lessor and Lessee:

Lessor

Lessee

Advantages Advantages
1.       Full Security – As Lessor is the real owner and can take repossession of the asset, his interest is fully secured

2.       Tax Benefits – As Lessor is the owner of the asset, he can also claim Depreciation. (Depreciation for Leased Assets is generally high), as a result Tax Benefit

3.       High Profits – Due to Higher Depreciation rate, there is quicker capital recovery.

4.       Trading on Equity – Lessor have low equity and they run their business on borrowed funds. Thus they carry out their operations with High Financial Leverage, results in High ROE

1.       100% Financing – Lease financing may be available upto 100% of Asset Cost

2.       No Dilution of Ownership

3.       Less Risk – Lessee has the option to opt for a lease proposal with latest technology.

4.       No Loss of Control – there are less documentation process is required in Leasing as compared to Institutional Financing.

5.       Tax Benefits – Benefits may accrue to Lessee based on suitable scheming of Lease Rentals

6.       Small Value Assets – Debt Financing in case of Small Value assets seems impracticable

7.       Eligibility to Borrow: The use of Leased Assets may not affect the borrowing capacity of the Lessee, as Lease Payment may not require normal lines of credit and are payable from income during the Operating period

Disadvantages Disadvantages
1.       High Payout – A Financial Lease may entail a higher pay out obligation, if the equipment is not found useful subsequently, and the Lessee opts for premature termination of the Lease arrangement

2.       Cost – In case of default by Lessee, it might leads to heavy damage to Lessor

1.       Restrictions on Use – Lessor imposes restrictions on use, as he is the owner

2.       No Ownership – as lessee is not the real owner, he is deprived of the residual value of the asset

3.       High Cost – On comparison, Lease Financing has higher interest than that of Term Loans

4.       No Moratorium – Lease Rentals are payable as soon as the leasing agreement is made, so there are cash outflows at the beginning itself. In case of New Projects, it may not be suitable.

5.       Understatement of Lessee’s Assets – Leased Assets do not appear in Lessee’s Balance Sheet. Even though he uses the assets, he cannot claim as the owner of the asset and cannot show in his Balance Sheet

6.       Double Sales Tax – Sales Tax in imposed by different states as a result of Lease Transactions. Here it results in double Taxation. As Lessor already paid Sales Tax at the time of Purchase of Asset.

7.       Default by Lessor – if Lessor bought the asset by taking credit, then on failure to pay any instalments, may results in seizure of the asset by the bank, causing loss to the Lessee.

Difference between Leasing and Hire Purchase

Leasing Hire Purchase
Ownership lies with lessor

Lessee only has the right to use the asset

Lessor is owner till the end of Agreement

Hirer has the option to purchase

Hirer becomes owner after payment of Last Instalment

Depreciation is claimed by Lessor Depreciation is allowed to Hirer
Lease Rentals covers Cost of Usage of Asset Hire Purchase Instalments involves Principal as well as Interest
Lease agreements are done for longer duration and on bigger assets Hire Purchase agreements are done mostly for shorter duration and cheaper assets
For Lessee, Lease Rentals are shown as Expense For Hirer, Only Interest  is shown as Expense
Complete Financing

No Down payments

Partial Financing

There is around 20-30% Down Payment

Evaluation of Lease Proposal

Lease2.PNG

Evaluation of Lease Proposal – Lessor point of view:

In case of Lessor it is an Investment Decision. That is if the Lease Proposal is beneficial then he will lease the asset.

Evaluation of Lease Proposal Using NPV Method:

1.       Computation of Cost of Asset

2.       Identification of Relevant Cash flows –

a.       Operating Cash flows (Lease Rentals)

b.      Terminal Cash flows

3.       Identification of Cost of Capital – Discounting Rate.

4.       Compute NPV = Discounted Cash Inflows – Discounted Cash Outflows.

5.       Decision – the Project is selected if NPV is positive, else rejected.

Evaluation of Lease Proposal Using IRR Method:

1.       Identify all Cash outflows of the project and the periods in which they are occurred.

2.       Identify all Cash Inflows of the Project and their periods.

3.       Compute NPV at any arbitrary discount rate, say 10%.

4.       Choose another Discount rate in such a way that the desired NPV is Negative, if the other is positive and positive if the other is Negative.

5.       Compute the change in NPV over the two selected discount rates.

On Proportionate basis, compute discount rate at which NPV = 0

Bower-Herringer-Williamson Method (BHW):

Here payment streams are divided into two parts – Cash flows associated with Financing and Cash Flows Associated with Tax Savings

Financial aspect : PV of Debt (-) PV of Lease Payments

Tax Aspect : Corporate Tax Benefit between Debt and Leasing alternatives, discounted at an appropriate Cost of Capital

Net Effect :  Net effect of above two aspects is advantage, accept the proposal

Rate of Discount being the Gross Cost of Debt Capital

Problems faced with IRR:

  1. Different Project Lives – IRR cannot be used to choose between alternative Leases which have different lives
  2. Tax Effect – If firms do not pay tax or pay tax at constant rate, then IRR should be calculated from Lease Cash Flows and compared with after tax rate of interest
  3. Inconsistency of Risk – in cases of Lease, the Lease Payments are fairly riskless and Interest rate should reflect this. The salvage value for the asset however is much riskier. Two different discount rates are required for these cash flows. IRR only gives one rate and thus each cash flow is not implicitly discounted to reflect its risk

Multiple Roots (Rate of Returns) – in case of Leasing, the lessee will have immediate cash inflow, a series of cash out flows and a inflow at the end of the period. With changes in cash flow there may be two solutions for IRR

Evaluation of Lease Proposal – Lessee point of View:

Cash Basis:
Particulars Amount
Cost of the Asset

Less:     Present Value of Tax Savings on Depreciation

Present Value of Cash Outflows

XXX

(XXX)

XXX

Borrow and Purchase
  1. Calculate EAI – Equated Annual InstalmentL1

Where,  r is IRR

2. Prepare Loan Amortization Table – Segregation of Interest and Principle components

3. Calculate Depreciation on Asset

4. Tax Savings on Depreciation and Interest

5. Net Cash Outflows – (1) – (4)

6. Calculate Present Value of Cash Outflows

Lease Options
Particulars Amount
Lease Rent

Less:      Tax Savings on Lease Rent

XXX

(XXX)

XXX

XX

XXX

Net Lease Rent

PVAF(r%, n years)

PV of Lease Rentals

An Option with Lower Cash Outflow will be preferred for Financing

Discounting Factor

POST TAX COST OF DEBT WEIGHTED AVERAGE COST OF CAPITAL
Pre-tax Cost of Debt (r %)

Less: Tax (t %)

Post Tax Cost of Debt (r (1-t) %)

1.       If asset is funded by equity, then Discounting Factor will be Cost of Equity

2.       If the asset is funded by combination of Debt and Equity, then Discounting Factor will be WACC.

Notes:

  1. Annual Operating Costs will be incurred whether or not the asset Is purchased or rented. So it is a common cost and is not relevant for present decision.
  2. Lease Rents can be paid at beginning of the year or at the end of the year. In that case while calculating PV Factors, this point is to be noted.

Lease3.PNG

Different Methods of Structuring Lease Rentals

  1. Equal Annual Plan – Lease Rentals are charged equally throughout the period of Lease
  2. Differed Lease Rentals – Lease Rentals are paid after an agreed initial time, generally it is paid as and when funds are generated from the operations of Lease
  3. Stepped up Lease Rentals – Constant rate of increase in the amount of Lease Rentals charged throughout the period of Lease
  4. Balloon Lease Rentals – Initial Lease Rentals are low and are increased as the Cash Flows generated by Lessee are increased.

Evaluation of Hire Purchase Transactions

  1. Find out the Hire Purchase instalments to be paid
  2. Find out the Interest amounts included in each Instalments. Interest is the difference between Total Consideration paid and Cash Down Price
  1. Calculate Depreciation on Asset
    1. As per Income Tax Act, Hirer is entitles to claim Depreciation on an Asset
  2. Calculate Tax Savings on Interest and Depreciation
  3. Net Cash Flows under Hire Purchase Transaction – (1)-(4)

Sale and Lease Back

Asset is not physically exchanged but is exchanged entirely through Book Entries.

Owner of the Asset sells the asset to a party and that party leases the same asset to the owner who initially sold the asset.

In this transaction, Seller becomes Lessee and Buyer becomes Lessor.

Example – A has a machine. He sells it to B for Selling Price. B in turn Leases it back to A for Lease Rentals.

A – Seller becomes Lessee – he gets Sale Proceeds and pays Lease Rentals

B – Buyer becomes Lessor – Pays Sale Proceeds and gets Lease Rentals.

The main advantage is that the Lessee can satisfy himself completely regarding the quality of the machine.

Sales-Aid Lease

Lessor enters in to a contract with manufacturer, to market the products of manufacturer through his own leasing operations. This is called Sales-Aid Lease.

In this case, Lessor gets commission from manufacturer and also Lease Rentals from Lessee, he gets inflows from two ways.

Leverage Lease

Here, Lessors borrows part of the amount from Lenders (Banks/ Financial Institutions) and purchase the asset and leases it to the Lessee. Here Lender is give Senior Secured Interest on the Asset and assignment of Lease and Lease Payments.

The transaction is routed through Trustee who looks after the interest of the Lessor and the lender. The trustee receives the rentals from Lessee and passes on to the Lender, and any surplus left goes to the Lessor.

Lessor can claim depreciation and tax benefits thereon.

Cross Border Leasing

Lessor and Lessee are situated in different countries.

It is considered as an alternative to Equipment Loans to Foreign Buyers.

In Case of Two Countries CBL – Lessor and Lessee are from different countries

In case of Three Countries CBL – Lessor, Lessee, Manufacturer are from three different countries

In case of Four Countries CBL – Lessee, Lessor, Manufacturer and Fourth Nation providing Debt are from different countries.

Advantages:

  1. Credit availability – Funding for longer period and at fixed rate may not be available at Lessee’s country can be obtained internationally, through CBL.
  2. Assets Choice – Choice of Assets for CBL is different than Domestic Lease, because those assets may find attractive bargain which are internationally mobile, have adequate Residual Value and enjoy undisputed title.
  3. Tax Savings – CBL is widely used to arbitrage the difference in tax laws of different countries, thus leading to tax avoidance and tax shelters
  4. Sale and Lease Back – Original owner of the asset is not subject to taxation in any country, so he need not claim depreciation, CBL involves selling such asset to an investor in such country and long leasing it back to the owner.
  5. Infrastructure – In developing countries, CBL is used as a means of financing infrastructure development
  6. Lower Cost – CBL reduces the overall cost of financing, particularly if Tax Savings are available to the Lessor, are passed through to Lessee as a lower cost of Finance.
  7. Security – Lessor is often able to utilize Non-Recourse Debt to finance a substantial portion of equipment cost.
  8. Accounting Treatment – sometimes, Lessor can utilize very favourable “Leveraged Lease” Financial Accounting treatment
  9. Repossession – In some countries, it is easier for a Lessor to repossess the leased equipment following a Lessee default because the Lessor is an Owner and not a mere Secured Lender.
  10. Defeasing and Currency Management – Appropriate Currency Requirements can be met easily to match the Specific Cash Flow needs of Lessee.

Concept of Breakeven Lease Rental

  1. From Lessee’s perspective
    1. Maximum Lease Rent the Lessee would be willing to pay
    2. If BELR
    3. At BELR, Lessee is indifferent between borrowing and leasing the asset
  2. From Lessor’s perspective:
    1. Minimum Lease Rental accepted by Lessor
    2. If BELR>Actual Lease Rent, the lessor should not accept the Lease proposal
    3. At BELR, net advantage of Leasing from Lessors viewpoint will be Zero
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