Lecture 12Lease Financing

Lease Financing

It has emerged as a supplementary source of financing.

Increase in off-balance sheet methods of financing.

Increase in scope of lease financing: Land & buildings in earlier times to

sophisticated equipment, aircrafts, etc.

Leasing A lease is a contract whereby the lessor

grants the lessee the right to use an asset in return for periodical lease rental payments.

Many types of leases: Finance vs. Operating. Direct vs. Sale & lease back. Single investor vs. Leveraged lease. Domestic vs. International.

Finance vs. Operating Lease Finance (Capital) Lease:

Medium to long term. Non-cancelable. Usually fully amortized during primary lease

period. Lessee is responsible for maintenance,

insurance, etc. Lessee usually enjoys the option of

renewing the lease for further period at substantially reduced lease rentals.

Finance vs. Operating Lease Operating Lease:

Term is significantly less than the economic life of equipment.

Lessee enjoys right to terminate the lease at short notice.

Wet Lease: Lessor is responsible for maintenance, insurance,

etc. Dry Lease:

Lessee is responsible for maintenance, insurance, etc.

Finance vs. Operating Lease

Operating Lease: Does not result in substantial transfer

of risks and rewards of ownership. Calls for in-depth knowledge of

equipment. Existence of secondary market.

Direct vs. Sale & Lease Back Sale & Lease Back:

Owner sells the asset to a leasing company and leases it back in order to enjoy the uninterrupted use of asset.

Usually used by manufacturing companies to unlock investment in fixed assets.

Difficult to establish a fair market value. IT Act: Lessor cannot claim depreciation at a higher

rate. Does not result in substantial transfer of risks and

rewards of ownership. Direct Lease:

Bipartite: Supplier-cum-lessor and lessee. Tripartite: Supplier, Lessee and lessor.

Single Investor vs. Leveraged Lease Single Investor: Lessor funds the entire

investment by raising an appropriate mix of debt and equity.

Leveraged Lease: The leasing company (equity participant)

and a lender (loan participant) jointly fund the investment in the asset.

Lender does not have recourse to the lessor and is secured by a first charge on future rentals payable by the lessee.

Domestic vs. International Lease

Domestic: All participants are domiciled in the same country.

International: One or more parties are domiciled in different countries. Intimate knowledge of economic &

political climate. Tax and regulatory framework. Risk: Country and Currency risks.

Rationale for Leasing

Dubious reasons: Preserves capital. Circumvention of certain internal

controls. Achieving favorable financial ratios.

Rationale for Leasing

Sensible reasons: Convenience. Benefits of standardization. Better utilization of tax shields. Fewer restrictive covenants. Better management of obsolescence risk. Expeditious implementation. Matching of lease rentals with cash flows.

Mechanics of Leasing

Legal Aspects of Leasing: No separate statute for leasing of equipments. Section 148 of Indian Contracts Act:

Relationship of Bailor and Bailee. Typical Contents of a Lease agreement:

Description of equipment. Amount, time and place of rental payments. Lessee’s rights and responsibilities. Variation clauses. Option for renewals and cancellations. Arbitration clause.

Mechanics of Leasing

Sales Tax Provisions: CST concessional rate not available. Many state governments have brought lease

transactions within the ambit of sales. Income Tax:

Depreciation is claimed by lessor. Lease rentals received by lessor are taxable as

ordinary income. Lease rentals paid by lessee are tax-deductible.

Mechanics of Leasing

Accounting Treatment: Operating leases are capitalized in the

books of lessor. Lease payments are treated as income of

lessor and expense of the lessee. Finance leases are capitalized in the

books of lessee. Leased asset is capitalized at present value of

committed lease rentals and is matched by liability called ‘lease payable’.

Operating Leases

In a competitive leasing industry lease rentals would be equal to: Equivalent Annual Costs of lessor.

Example: Cost of equipment = 75000. Opex = 12000 in each year. Lease period = 7 years (0 to 6). Real cost of capital = 7%. Zero salvage value. Lease rentals paid in advance. 35% tax rate.

Operating Leases0 1 2 3 4 5 6

Capex -75

Opex -12 -12 -12 -12 -12 -12 -12

Tax shield

4.2 4.2 4.2 4.2 4.2 4.2 4.2

Dep Tax Shield

5.25 8.4 5.04 3.02 3.02 1.51

TotalPV@7%98.15

-82.8 -2.55 .60 -2.76 -4.78 -4.78 -6.29

Break-even rent

26.18 26.18 26.18 26.18 26.18 26.18 26.18

Rental after tax

17.02 17.02 17.02 17.02 17.02 17.02 17.02

Finance Leases Leasing is treated as a financing decision. Leasing is compared with the option of

buying with borrowed funds. Example: Cost of equipment = 10 million.

Opex = 12000 in each year. Life = 6 years. Cost of borrowing = 15.4%. Salvage value = 1million. Dep =40% WDV method.

Lease rentals of 2.4 million paid in arrears. 35% tax rate.

Finance Lease0 1 2 3 4 5 6

Capex 10

Dep 4 2.4 1.44 0.86 0.52 0.31

Loss of Dep Tax shield

-1.4 -0.84 -0.50 -0.30 -0.18 -0.11

Lease payment

-2.4 -2.4 -2.4 -2.4 -2.4 -2.4

Tax Shield

0.84 0.84 0.84 0.84 0.84 0.84

Loss of salvage val.

-1.0

Cash flow of lease

10 -2.96 -2.4 -2.06 -1.86 -1.74 -2.67

Finance Leases NPV of Lease can be calculated by using

different discount rates for each cash flow item.

But in practice we can use post-tax cost of borrowing as discount factor.

NPV = -0.16 million. This implies that company was better

off borrowing and buying the asset than leasing it.

Finance Leases IRR: IRR of lease can be compared

with post-tax cost of debt. Equivalent Loan Amount:

We can calculate how much loan can be serviced with the lease cash flows.

This can be compared with financing provided by lease.

NPV of Lease = Initial financing provided by lease – Equivalent loan amount.

Leasing vs. Buying

If asset is required for a short period: Lease it.

If asset is required for a long period: Buy the asset if post-tax EAC of ownership and

operation is less than post-tax lease rental. Lease the asset if post-tax EAC of ownership and

operation is more than post-tax lease rental. Usually lessor marks up the lease rate to cover the

cost of: Negotiation. Administration. Revenues foregone during idle time. Risk of diminishing utility of asset.

Leasing vs. Buying

In some circumstances leasing for long periods makes sense: Lessor is more efficient in buying and

managing the asset. Lessor can operate at lower costs and

extract better salvage values. Lease agreement contains valuable

options to: Cancel or Continue the lease agreement.