·4 ChapterObjectivesAfter completing this chapter, you will be able to understand:• Types of Lease. '• Lease and Hire Purchase.• Lease and Taxation.• Accounting for lease.Structure:4.1 Introduction4.2 Concept of Leasing4.3 Step Involved in Leasing Transaction4.4 Types of Lease4.5 Operating Lease4.6 Leverage Lease4.7 Sale and Lease Back4.8 Cross Border Lease4.9 Installment Buying, Hire Purchase and Leasing4.10 History and Development of Leasing4.11 Legal Aspects of Leasing4.12 Contents of a Lease Agreement4.13 Income Tax Provisions Relating to Leasing4.14 Sales Tax Provisions Pertaining to Leasing4.15 Accounting Treatment of-Lease4.16 Structure of Leasing Industry4.17 Public Sector Leasing4.18 Problems of Leasing4.19 Prospects4.20 Summary4.21 Self Assessment Questions4.1 INTRODUCTIONTraditionally firms acquire productive assets and use them as owners. The sources of finance to a firm for finance to a firm for procuring assets may be internal or external. Over the years there has been a declining trend in the internally generated resources of Indian companies due to low profitability. the financial institutions experience paucity of funds at their disposal to meet the increasing needs of borrowers. Further, modern business environment is becoming more and more complex. To succeed in the situation, the firms aim at growth with stability. To accomplish this objective, firms are required to go for massive expansion, diversification and modernization. Essentially such projects involve a huge amount of investment. High rate of inflation, severe costescalation, heavy taxation and meager internal resources forced many companies tolook for alternative means of financing the projects. Leasing has emerged as a newsource of financing capital assets.4.2 CONCEPT OF LEASINGLeasing, as a financing concept, is an arrangement between two parties, theleasing company or lessor and the user or lessee, whereby the former arranges to buycapital equipment for the use of the latter for an agreed period of time in return for thepayment of rent. The rentals are predetermined and payable at fixed intervals of time,

according to the mutual convenience of both the parties. However, the lessor remainsthe owner of the equipment over the primary period.By resorting to leasing, the lessee company is able to exploit the economic valueof the equipment by using it as if he owned it without having to pay for its capital cost.Lease rentals can be conveniently paid over the lease period out of profits earnedfrom the use of the equipment and the rent is cent percent tax deductible.A Lease is Defined as follows:- Dictionary of Business and Management -'Lease is a form of contract transferring the use or occupancy of land, space,structure or equipment, in consideration of a payment, usually in the form of a rent.'- James C. Van Horne -'Lease is a contract whereby the owner of an asset (lessor) grants to anotherparty (lessee) the exclusive right to use the asset usually for an agreed period of timein return for the payment of rent.'- Equipment Leasing Association of UK -'A Contract between lessor and lessee for the hire of a specific asset selectedfrom a manufacturer or vendor of such assets by the lessee. The lessor retains theownership of the asset. The lessee has possession and use of the asset on paymentof specified retain over the period.'Thus in a contract of lease there are two parties involved (i) lessor and the lessee.The lessor can be a company, a co-operative society, a partnership firm or an individualin manufacturing or allied activities. The lessee can be even a doctor or any otherspecialists who use costly equipment for the practice of his profession.Leasing as a Source of FinanceLeasing is an important source of finance for the lessee. Leasing companiesfinance for:1. Modernisation of business.2. Balancing equipment.3. Cars, scooters and other vehicles and durables.4. Items entitled to 100% or 50% depreciation.5. Assets which are not being financed by banks/institutions.4.3 STEP INVOLVED IN LEASING TRANSACTIONThe steps involved in a leasing transaction are summarised as follows:1. First, the lessee has to decide the asset required and select the supplier. Hehas to decide about the design specifications, the price, warranties, terms of delivery,servicing etc.2. The lessee, then enters into a lease agreement with the lessor. The leaseagreement contains the terms and conditions of the lease such as,(a) The basic lease period during which the lease is irrecoverable.(b) The timing and amount of periodical rental payments during the leaseperiod.(c) Details of any option to renew the lease or to purchase the asset at theend of the period.(d) Details regarding payment of cost of maintenance and repairs, taxes,insurance and other expenses.3. After the lease agreement is signed the lessor contacts the manufacturer and

requests him to supply the asset to the lessee. The lessor makes payment to themanufacturer after the asset has been delivered and accepted by the lessee.4.4 TYPES OF LEASEThe lease agreement can be classified broadly into four categories:1. Financial LeaseA financial lease is also known as Capital lease, Long-term lease, Net lease andClose lease. In a financial lease, the lessee selects the equipments, settles the riceand terms of sale and arranges with a leasing company to buy it. He enters into airrevocable and non-cancellable contractual agreement with the leasing company.The lessee uses the equipment exclusively, maintains it, insures and avails of the aftersales service and warranty backing it. He also bears the risk of obsolescence as itstands committed to pay the rental for the entire lease period.The financial lease could also be with purchase option, where at theend of thepredetermined period, the lessee has the option to buy the equipment at a predeterminedvalue or at a nominal value or at fair market price. The financial lease may also containa non cancellable clause which means that the lessor transfers the title to the lesseeat ·the end of the lease period.Under a financial lease, the rate of lease would be fixed based on the kind oflease, the period of lease, periodicity of rent payment, and the rate of depreciation andother tax benefits available. The leasing company also charges nominal servicecharges to cover legal and other costs. The leasing company may also insist oncollaterals or bank's guarantee in individual cases. In a large number of cases, thefinancial leases are used as financing cum tax planning tool.The .financial lease is very popular in India as in other countries like USA, UK andJapan. On an all India basis, at present, approximately a lease worth Rs. 75 to Rs. 100crores is transacted as a tax planning device. The high cost of equipments such asoffice equipment, diesel generators, machine tools, textile machinery, containers,locomotives etc., are leased under financial lease.4.5 OPERATING LEASEAn operating lease is also known as Service lease, Short term lease or Truelease. In this lease, the contractual period between lessor and lessee is less than thefull expected economic life of equipment. This means that the lease is for a limitedperiod, may be a month, six months, a year or few years. The lease is terminable bygiving stipulated notice as per the agreement. Normally, the lease rentals will behigher as compared to other leases on account of short period of primary lease. Therisk of obsolescence is enforced on the lessor who will also bear the cost of maintenanceand other relevant expenditure. The lessor also does the services like handling warrantyclaims, paying taxes, scheduling and performing maintenance and keeping completerecords lease is suitable for,(i) Computers, copy machines and other office equipments, vehicles, materialhandling equipments etc. Which are sensitive to obsolescence and(ii) Where the lessee is interested in tiding over temporary problem.Distinction between a Financial Lease and Operating LeaseFinancial Lease Operating Lease1. A financial lease is like an installmentloan. It is a legal commitment to pay

for the entire cost of the equipment plusinterest over a specified period of time ..The lessee commits to a series ofpayment which in total exceed the costof the equipment.2. It excludes provisions for maintenanceor taxes which are paid separately bythe lessee.3. The risk of obsolescence is assumedby the lessee4. Contract period ranges from medium tolong term.5. Contracts are usually non cancellable.6. Air crafts, land and building heavymachinery are leased.7. The lease involves a financialcommitment similar to a loan by aleasing company. It places the lesseein a position of borrow,8. The lessor fulfills financial function.1. An operating lease is a rental agreement.The lessee is not committed to payingmore than the original cost of equipmentduring contractual period.2.0perating lease provides for maintenanceexpenses and taxes of the lessor.3. Leasing company assumes risk ofobsolescence.4. Contract period ranges from intermediateto short-term.5. Contracts are usually cancellable eitherby the lessor or by the lessee.6. Computers, office equipments,automobiles, truck etc. are leased.7. The financial commitment is restrictedto regular rental payment. The rentalsfind a place in the P & LAic of thelessee.8. The lessor fulfills service function.4.6 LEVERAGE LEASEA leverage lease is used for financing those assets which require huge capitaloutlay. The outlay for purchase cost of the asset generally varies from Rs. 50 lakhsto Rs. 2 crore arid has economic life of 10 years or more. The leverage lease agreementinvolves three parties, the lessee, the lessor and the lender. The lessor acquires theassets as per the terms of the lease agreement but finances only a part of the total. investment, say 20% to 50%. The balance is provided by a person or a group of

persons in the form of loan to the lessor. The loan is generally secured by mortgageof the asset besides assignment of the leased rental payments -,The position of thelessee under a leveraged leasing agreement is the same as in the case of any othertype of lease. In leveraged lease, a wide range of equipments such as rail road, rollingstock, coal mining, electricity generating plants, pipe lines, ships etc. are acquired.Under a leverage lease, there are some attractive investment features in theform of after-tax consequences for the owner of the equipment. By investing 20.% or25% of the cost of an asset, the lessor is entitled to 100% allowance for depreciationplus the investment allowance. In addition, interest expenses related to his borrowingsare also tax deductible. From the point of view of lessee, lease rentals are deductiblein full as an operating expense.4.7 SALE AND LEASE BACKUnder this type of lease, a firm which has an asset sells it to the leasing companyand gets it back on lease. The asset is generally sold at its market value. The firmreceives the sale price in cash and gets the right to use the asset during the leaseperiod. The firm makes periodical rental payment to the lessor. The title to the assetvests with the lessor. Most of the lease back agreements are on a net - net basiswhich means that the lessee pays all maintenance expenses, property taxes and-insurance. In some cases, the lease agreement allows the lease to repurchase theproperty at the termination of lease.The sale and lease back agreement is beneficial to both lessor and lessee. Thelessor gets immediate cash which becomes available for working capital or for furtherexpansion and lessor gets tax benefits. Retail stores, office buildings, multipurposeindustrial building and shopping centres are financed under this method.4.8 CROSS BORDER LEASECross border lease is international leasing and is known as transnational leasing.It relates to a lease transaction between a lessor and lessee domiciled in differentcountries and includes exports leasing. In otherwords the lessor may be of onecountry and the lessee may be of another country. To illustrate, if a leasing companyin USA makes a available an Air bus on lease to Air India, there would be a cross borderlease.Indian leasing industry is unlikely to deal in export border leases for big ticketitems such as aircraft but it is well placed to contribute to India's export earnings byoffering the lease option. First Leasing Company has initiated discussions with BulgarLeasing of Bulgaria to export bull dozers and shovels in significant number of anexport lease to that country.4.9 INSTALMENT BUYING, HIRE PURCHASE AND LEASINGIn instalment buying, the property passes on to the buyer immediately as soonas the first installment is made. The balance amount is payable in installments. Underthe contract of installment the buyer has no right to return the goods. In case of default,the seller has the right to file a suit in the court of law to recover his dues.Hire purchase is an agreement under which the owner delivers the goods to thebuyer who agrees to.make periodical payment as hire charges. The possession ofgoods vests with the hirer but the ownership remains with the seller. On full paymentof hire charges, the buyer gets the option of purchasing the goods. On default, theseller can reclaim the goods, subject to certain provisions of Hire Purchase Act.

Hire purchase resembles leasing in certain ways. In both the cases th~ right to.use the equipment is transferred to .the hirer/lessee. .. . = ... ,In leasing, the entire lease rentals represents a hire charge and it is treated asexpense and hence tax deductible. Under hire purchase, a part of installment representscapital payment and hence it is not an expense. A part of the installment is interest onthe loan which is considered as revenue expenditure and hence it is tax deductible.In leasing, rental charges are debited to profit and loss account and the leasedasset is not shown in the balance sheet of the lessee. As against this, the hire purchasercapitalises the asset brought under hire purchaser contract. The liability for future hirepurchase installments not yet due is shown separately in the balance sheet.Advantages of LeaseThe following are the advantages of leasing:1. Permit Alternative Use of Funds: A leasing arrangement provides a firm withthe use and control over asset without incurring huge capital expenditure. The firm isrequired only to make periodical rental payments. It saves considerable funds foralternative uses which would otherwise be tied up in fixed capital. •2. Faster and Cheaper Credit: Depending on tax structure of the lessee it costsless than other methods of acquiring assets. It permits firms to acquire new equipmentwithout going thorough formal scrutiny procedure. Hence acquisition of assets underleasing agreement is cheaper and faster than any other source of finance.3. Flexibility: Leasing arrangements may be tailored to the lessee's needsmore easily that ordinary financing. Lease rentals can be structured to match thelessee's cash flows. It can be skipped during the months when the cash flows areexpected to below.4. Facilitates Additional Borrowings: Leasing may increase long-term abilityto acquire funds. The lessee can utilise more funds for working capital needs. Moreover,acquisition of assets under the lease agreement does not alter debt equity ratio.Hence, the lessee can go for additional borrowings in case need arises.5. Protection against obsolescence: A firm can avoid risk of obsolescence byentering into operating lease agreement. This is highly useful in respect of assetswhich become obsolete at a faster rate.6. No Restrictive Covenants: The restrictive covenants such as debt equityratio, declaration of dividend etc., which are usually imposed under debenture or loanagreement are absolutely absent in a lease agreement.7. Hundred Percent Financing: Lease financing enables a firm to acquire theuse of an asset without having to make a down payment. So hundred percent financingis assured to the lessee.8. Boon to Small Firm: The firms which are either small or have uncertainrecords of earning are able to obtain the use of asset through lease financing. It is aboon to small firms and technocrats who are able to make promoter's contribution asrequired by financial institutions.Disadvantages of Leasing1. Lease is not suitable mode of project finance. This is because rentals arerepayable soon after entering into lease agreement while in new projects cash generationsmay start only after a long gestation period.2. Certain tax benefits/incentives such as subsidy may not be available on leased

equipment.3. The value of real assets such as land and building may increase during leaseperiod. In such a case the lessee loses the advantage of a potential capital gain.4. The cost of financing is generally higher than that of debt financing.5. A manufacturer who wants to discontinue a particular line of business will notin a position to terminate the contract except by paying heavy penalties. If it is a ownedasset the manufacturer can sell the equipment at his will.6. If the lessee is not able to pay rentals regularly, the lessor would suffer a lossparticularly when the asset is a sophisticated one and less liquid.7. In case of lease agreement, it is lessor who has purchased the asset from thesupplier and notthe lessee. Hence, the lessee by himself is not entitled to any protectionin case the supplier commits breach of warranties in respect of the leased assets.8. In the absence of exclusive laws dealing with the lease transaction, severalproblems crop up between lessor and lessee resulting in unnecessary complicationsand avoidable tension.4.10 HISTORY AND DEVELOPMENT OF LEASINGThe history of leasing dates back to 200 BC when Sumerians leased goods.Romans had developed a full body law relating to lease for movable and immovableproperty. However the modern concept of leasing appeared for the first time in 1877when the Bell Telephone Company began renting telephones in the U.S.A. In 1832,Cottrell and Leonard leased academic caps, gowns and hoods. Subsequently, during1930s the Railway Industry used leasing service for its rolling stock needs. In the postwar period, the American Air Lines leased their jet engines for most of the new aircrafts. This development ignited immediate popularity for the lease and generatedgrowth of leasing industry.Since World War II the use of leasing has been greatly expanded and is constantlyused for new products and new industries. In May 1952, Henry Scholfeld set up aseparate Corporation in the USA to handle lease transaction. He founded the USLeasing Corporation with a capital of $20,000. Since 1963, commercial banks havebeen allowed to engage themselves in direct leasing. In the early 1960s leasingentered the United Kingdom following its successful and rapid development in theUSA.The concept of financial leasing was pioneered in India during 1973. The FirstCompany was setup by the Chidambaram group in 1973 in Madras. The companyundertook leasing of industrial equipment as its main activity. The Twentieth centurvLeasing Company Limited was established in 1979. By 1981, four finance companiesjoined the fray. The performance of First Leasing Company Limited and the TwentiethCentury Leasing Company Limited motivated others to enter the leasing industry. In1980's financial institutions made entry into leasing business. Industrial Credit andInvestment Corporation was the first all India financial institution to offer leasing in1983. Entry of commercial banks into leasing was facilitated by an amendment ofBanking Regulation Act, 1949. State Bank of India was the first commercial bank toset up a leasing subsidiary, SBI capital market, in October 1986. Can Bank FinancialServices Ltd., BOB Financial Service Ltd., and PNB Financial Services Limited followedsuit. Industrial Finance Corporation's Merchant Banking division started financingleasing companies as well as equipment leasing and financial services. There was

thus virtual explosion in the number of leasing companies rising to about 400 companiesin 1990.In the subsequent years, the adverse trends in capital market and other factorsled to a situation where apart from the institutional lessors, there were hardly 20 to 25private leasing companies who were active in the field. The total volume of leasingbusiness transacted, by both private and public sector leasing companies was Rs.5000crores in 1993 and it is expected to cross Rs. 10,000 crores by March 1995.4.11 LEGAL ASPECTS OF LEASINGAs there is no separate statute for equipment leasing in India, the provisionsrelating to bailment in the Indian Contract Act govern equipment leasing agreementsas well Section 148 of the Indian Contract Act defines bailment as:"The delivery of goods by one person to another, for some purpose, upon acontract that they shall, when the purpose is accomplished, be returned or otherwisedisposed off according to the directions of the person delivering them. The persondelivering the goods is called the' bailor' and the person to whom they are deliveredis called the 'bailee".Since an equipment lease transaction is regarded as a contract of bailment, theobligations of the kessor and the lessee are similar to those of the bailor and the bailee(other than those expressly specified in the least contract) as defined by the provisionsof sections 150 and 168 of the Indian Contract Act. Essentially these provisions havethe following implications for the lessor and the lessee.1. The lessor has the duty to deliver the asset to the lessee, to legally authorisethe lessee to use the asset, and to leave the asset in peaceful possession of the lesseeduring the currency of the agreement.2. The lessee has the obligation to pay the lease rentals as specified in the leaseagreement, to protect the lessor's title, to take reasonable care of the asset, and toreturn the leased asset on the expiry of the lease period.4.12 CONTENTS OF A LEASE AGREEMENTThe lease agreement specifies the legal rights and obligations of the lessor andthe lessee. It typically contains terms relating to the following:1. Description of the lessor, the lessee, and the equipment.2. Amount, time, and place of lease rental payments.3. Time and place of equipment delivery.4. Lessee's responsibility for taking delivery and possession of the leasedequipment. -5. Lessee's responsibility for maintenance, repairs, registration, etc. and thelessor's right in case of default by the lessee.6. Lessee's right to enjoy the benefits of the warranties provided by the equipmentmanufacturer/supplier.7. Insurance to be taken by the lessee on behalf of the lessor.8. Variation in lease rentals if there is a change in certain external factors likebank interest rates, depreciation rates, and fiscal incentives.9. Option of lease renewal for the lessee.10. Return of equipment on expiry of the lease period.11. Arbitration procedure in the event of dispute.4.13 INCOME TAX PROVISIONS RELATING TO LEASING

The principal income-tax provisions relating to leasing are as follows:1. The lessee can claim lease rentals as tax-deductible expenses.2. The lease rentals received by the lessor are taxable under the head of 'Profitsand Gains of Business or Profession'.3. The lessor can claim investment allowance (this may be doubtful) anddepreciation on the investment made in leased assets.4.14 SALES TAX PROVISIONS PERTAINING TO LEASING•The major sales tax provisions relevant for leasinq are as follows:1. The lessor is not entitled for the concessional rate of central sales tax becausethe asset purchased for leasing is meant neither for resale nor for use inmanufacture. (It may be noted that if a firm buys an asset for resale or for usein manufacture it is entitled for the confessional rate of sales tax).2. The 46th Amendment Act has brought lease transitions under the purviewof 'sale' and has empowered the central and state government to levy salestax on lease transactions. While the Central Sales Tax Act has yet to beamended in this respect, several state governments have amended theirsales tax laws to impose sales tax on lease transactions.4.15 ACCOUNTING TREATMENT OF LEASEAll particulars generally required as per legal requirements specified in ScheduleVI of the Companies Act.will also apply to leasing. The accounting treatment in thebooks of the lesser will be as follows:Books of Lessor(i) The lesser has to disclose the asset given under lease agreement as anasset in his balance sheet as per the method adopted for other fixed assets.(ii) The lease rentals received under financial lease should be shown in theincome statement on the credit side under the head 'Gross Income'.(iii) The lease rentals received should be shown on actual basis and not onaccrual basis.(iv) A minimum statutory depreciation on leased asset should be charged toincome statement separately.(v) Generally, a fair value of the leased asset to be recovered every year isascertained and it is called 'annual lease charge'.(vi) When the annual lease charge is more than the statutory depreciation, thedifference is called Lease equalisation charge. It is also charged to Incomestatement.(vii) When the annual lease charge is less that the statutory depreciation, thedifference is again called lease equalisation charge. But, it is credited in theincome statement.(viii) For adjusting the annual lease charge stated above a lease. EqualisationAccount and a Lease Adjustment Account will be opened as follows:(a) When the Annual Lease Charge is more than the Minimum StatutoryDepreciation the Entry to be Passed is:Lease Equalisation Account Dr.To Lease Adjustment Alc(b) When the Annual Lease Charge is less than the Minimum Statutory

DepreciationLease Adjustment Alc Dr.To Lease Equalisation AccountNote: Balance in Lease Adjustment Alc will appear in the Balance Sheet whereasthe Lease Equalisation Alc will go to the Income Statement as shown below:Dr. Profit and Loss Account Cr.By Gross Incomexxxxx Lease rentalAdd: Lease Equalisation(or)Less:Lease EqualisationxxxxxTo StatutoryDepreciationxxxxxBalance SheetAssetsFixed AssetsLeasehold Asset xxxxxLess:AccumulatedDepreciation xxxLess:Lease Adjustment xxx xxxxxBooks of LesseeFor the financial lease, no special treatment is necessary in the books of thelessee since it is a off-balance sheet financing. Hence the following treatment isnecessary:(i) The assets taken under lease agreement should be shown by way of afootnote in the Balance Sheet.(ii) However, the lease rentals paid should be charged to the Income Statement.(iii) The lease rentals should be shown on accrual basis. Hence, necessaryadjustments should be made for any outstanding or prepaid lease rent in theincome statement as well as in the Balance Sheet.(iv) It is also desirable to disclose the future obligations of the lease as per leaseagreement by way of a footnote.Method of Ascertaining Lease RentalsFrom the lessee's point of view, as seen already, he has to make an importantfinancial decision - whether to buy a capital equipment or take it on a lease basis.Similarly, from the lessor's point of view, he has to be very careful in computing thelease rentals so that he may not suffer due to any loss at a later stage. Generally, thefollowing method is adopted for determining the lease rentals:Determination of Lease RentalsThe following steps may be adopted for determining the lease rentals:1. First, findout the total cost of the asset.Total cost = Cost of the asset + Freight charges + Insurance + Taxes +Installation charges etc.2. Then, ascertain the cash flows to the lessor on account of ownership of the

asset. While ascertaining the cash flows, the tax advantage on depreciation, investmentallowance, if any etc. should be taken into account. The cash flows should be computedfor each year separately as follows:Cash flow = Amount of depreciation - Tax advantage on depreciation - Taxadvantage on Investment allowance + *Salvage value*Note: It should be considered only in the last year of the life of the asset.3. The new step is to calculate the present value of already computed cash flows(as stated in Step 2) year-wise with the help of P.V. factor. Generally the present valueFactor at a certain percentage discount rate will be given. So, it is easy to calculatethe PV of cash flows as follows:For example: PV factor @ 10% discountI Year = 0.813, II Year = 0.717, III Year = 0.697, IV Year = 0.606, V Year = 0.517PV of cash flows = Cash flow for each year x PV factor at a given discount rate4. The fourth step is to ascertain the minimum required net recovery throughlease rentals with the help of the following formula.Minimum required net recovery = Cost of the - The present valuethrough Lease Rental (MRLR) asset (Step 1) of cash flow (step 3)5. From this MRLR, it is easy to find out the post-tax lease rentals with the helpof the present value factor of annuity. This annuity discount factor at the specifieddiscount rate for a specified period will also be given. For egoAnnuity Discount factorat 10% Discount for 5 years = 3.105.MRLRPost-tax lease rental (PTLR) = PVfactor 0f Anrun'ty6. Finally, the pre-tax lease rentals can be ascertained by adjusting the PTLRfor the tax factor as follows:100Pre-tax lease rental (LR) = PTLR x ----Tax RateFrom this, lease rental for each month can be computed. Usually this rent will beexpressed in terms of per thousand and per month.10000 1Therefore the rate per month = Pre-tax lease rental (CR)x .. x-Total cost of the asset 12Buy or Lease DecisionSuccessful financial management requires taking sound financial decisions atthe appropriate time. One such decision is to decide whether to buy a capital assetor to take it on a lease basis. These two alternate proposals should be carefully studiedbefore taking any final decision. The financial viability of both the proposals should beevaluated by adopting the normal technique of capital budgeting. Generally, the NPV(Net Present Value) technique is used for this purpose. The present values of net cashoutflows after tax from these two options should be compared and the one with lowerpresent value of cash outflows is to be selected.Decision-making ProcessFor taking a final decision, the following factors should be taken into account:(i) As usual calculate depreciation on the capital asset to be bought by applyingthe formula:

D .. Cost of Asset - Salvage Value epreclation = --------=----No. of Years of Life(ii) Then, ascertain savings in tax on depreciation with the help of the tax rate.Saving in tax on depreciation = Depreciation x Tax rate(iii)Similarly, find out savings in.tax on interest paid with the help of the tax ratefor the given period.(iv) Then, calculate the Present Value of After Tax cash outflows under purchaseoption with the help of the appropriate discount rate (minimum required rate of return).Generally, the present value of Re.1 due for the given period (any number ofyears) can be found with the help of the following formula:1PV = (l + r)"where, PV means present valuer refers to rate of interest/discountn means number of years.(v) For buy or lease decisions, the present value is found out by multiplying theNet Cash outflow with the PV factor @ the discount rate.(vi) Similarly, calculate the present value of After-tax cash outflows under leaseoption.(vii) Finally, see which proposal has the lower present value of cash outflows. Forexample, after discounting all the after-tax cash outflows to the present value, overthe life of the asset say 10 years, we getNPV of buying = xPPV of leasing = yIf Y is lesser leasing option it has to be preferred and if x is lesser buying optionit has to be chosen.Other Factors Influencing Buy/Borrow or Lease DecisionA firm may propose to acquire a certain asset either with equity funds or with afinancial lease. The firm's management in such a case, should take into considerationcertain factors while evaluating the above financial proposals. These factors are:1. Capital Adequacy: If the firm has adequate shareholders' equity it is betterto go for buying the asset rather than taking it out on a lease basis. In the absence ofsufficient capital, raising new capital or retaining a greater proportion of earningsshould be considered rather than assuming further debt obligations through leasing.2. Liquidity Considerations: A firm has to maintain sufficient liquidity for meetingany sudden shortfall in cash inflows or for meeting any capital expenditures. If sufficientliquidity is not available, leasing is the solution.3. Flexibility Considerations: Buying an asset involves one time paymentwhich can not be flexible. If the asset is bought through borrowed funds, that will berigid repayment schedule. On the other hand leasing arrangements may be tailoredto the lessee's needs more easily and lease rentals can be structured to match thelessee's cash flows. .4. Nature of Asset: For those assets which become obsolete at a faster rate,'buying' that asset is not preferable. The best solution is to go for operating leasingwhich serves as a protection against obsolescence.5. Availability of Finance: In the absence of adequate owned funds, one has

to go for borrowed funds to buy an asset. There is no guarantee for the continuousavailability of borrowed funds and there is a fear of repayment on demand stipulatedby some lending institutions. On the other hand fixed-rate finance may be availableby leasing the equipment and there is also a guaranteed continuous availability offinance. Again, there may not be any restrictive covenants under leasing which arenormally found in all loan agreements.6. Debt Capacity: From the lessee's point of view leasing is off-balance sheetfinancing and hence it increases the overall debt capacity of a firm. Leasing plays avital role in a firm's overall financing strategy to the extent to which it enables the firmto increase its overall debt raising capacity. Hence, buy or lease decision dependsupon the financing strategy of a firm also.7. Grants and Incentives Consideration: Government grants, incentives andother benefits are available for purchased equipment as well as leased equipmentdepending upon the government's policy. Therefore, the method of finance either tobuy or lease should take into account the eligibility conditions to avail of such grantsand incentives.8. Borrowing Restrictions: Borrowings for the purpose of acquiring an assetmay not be permitted due to some restrictive covenants and government regulations.Sometimes the memorandum may restrict the borrowing powers of the company. Insuch cases leasing is the only answer to acquire such assets.9. Administrative Considerations: Buy or lease decision depends 'onadministrative conveniences like simplicity of book-keeping procedures, easy cashflow forecasting etc. Generally firms prefer those methods of finance which facilitateeasy administration.4.16 STRUCTURE OF LEASING INDUSTRYThe present structure of leasing industry in India consists of (i) Private SectorLeasing and (ii) Public Sector Leasing.The private sector leasing consists of:(i) Pure Leasing Companies,(ii) Hire Purchase and Finance Companies, and(iii) Subsidiaries of Manufacturing Group Companies.The public sector leasing organisations are divided into:, (i) leasing divisions of financial institutions,(ii) subsidiaries of public sector banks, and(lli) other public sector leasing organisations.(i) Pure Leasing CompaniesThese companies operate independently without any link or association with anyother organisation or group of organisation. The First Leasing Company of IndiaLimited. The Twentieth Century Finance Corporation Limited, and the Grover LeasingLimited, fa" under this category.(ii) Hire Purchase and Finance CompaniesThe companies started prior to 1980 to do hire purchase and finance businessespecially for vehicles added leasing to their activities during 1980. Some of them doleasing as major activity and some others do leasing on a small scale as a tax planningdevice. Sundaram Finance Limited and Motor and General Finance Limited belongto this group.

(iii) Subsidiaries of Manufacturing Group CompaniesThese companies consist of two categories,(a) Vendor leasing .(b) In house leasing(a) Vendor Lea.sing: This type of companies are formed to boost and promotethe sale of its parent companies' products through offering leasing facilities.(b) In House Leasing: In house leasing or capture leasing companies are set upto meet the fund requirements or to avoid the income tax liabilities of the gr.oupcompanies.4.17 PUBLIC SECTOR LEASING(i) Financial Institutions: The financial institution such as IFCI, ICICI, IRBI andNSIC have set-up their leasing divisions or subsidiaries to do leasing business. Theshipping credit and Investment company of India offers leasing facilities in foreigncurrencies for ships, deep seas fishing vehicles and related equipments to its clients.(ii) Subsidiaries of Banks: The commercial banks in India can, under section19(1) of the Banking Regulation Act, 1949, setup subsidiaries for undertaking leasingactivities. The SBI was the first bank to start a subsidiary for leasing business in 1986.Leasing in SBI is transacted through, Strategic Business Unit (SBU) of the bank.EachSBU is manned by specially trained staff and isequipped with the latest technologicalaids to meet the needs of top corporate clients. For the bank as a whole, leasing isconsidered as a high growth area. Now the bank is concentrating only on 'Big TicketLeasing' which is generally of Rs. 5 crore and above. So far SBI has disbursed morethan Rs. 300 crores by way of leasing with the average size of deal being Rs. 25 crores.(iii) Other Public Sector Organisations: A few public sector manufacturingcompanies such as Bharat Electronics Limited, Hinudustan Packaging CompanyLimited, Electronic Corporation of India Limited have started to sell their equipmentthrough leasing.4.18 PROBLEMS OF LEASINGLeasing has great potential in India. However, leasing in India faces serioushandicaps which may mar its growth in future. The following are some of the problems.(i) Unhealthy CompetitionThe market for leasing has not grown with the same pace as the number oflessors. As a result, there is over supply of lessors leading to competition. With theleasing business becoming more competitive, the margin of profit for lessors hasdropped from four to five percent to the present 2.5 to 3 percent. Bank subsidiariesand financial institutions have the competitive edge over the private sector concernsbecause of cheap source of finance.(ii) Lack of Qualified PersonnelLeasing requires qualified and experienced people at the helm of its affairs.Leasing is a specialised business and persons constituting its top management shouldhave expertise in accounting, finance, legal and decision areas. In India, the conceptof leasing business is of recent one and hence it is difficult to get right man to deal withleasing business. On account of this, operations of leasing business are bound tosuffer.(iii) Tax ConsiderationsMost people believe that lessees prefer leasing because of the tax benefits if

offers. In reality, it only transfers, the benefit, i.e., the lessee's tax shelter is lessor'sburden. The lease becomes economically viable only when the transfer'S effective taxrate is low. In addition, taxes like sales tax, wealth tax, additional tax, surcharge etc.add to the cost of leasing. Thus leasing becomes more expensive from of financingthan conventional mode of finance such as hire purchase.(iv) Stamp DutyThe States treat a leasing transaction as a sale for the purpose of making themeligible to sales tax. On the contrary, for stamp duty, the transaction is treated as apure lease transaction. Accordingly a heavy stamp duty is lived on lease documents.This adds to the burden of leasing industry.(v) Delayed Payment and Bad DebtsThe problem of delayed payment of rents and bad debts add to the costs of lease.The lessor does not take into consideration this aspect while fixing the rentals at thetime of lease agreement. These problems would disturb prospects of leasing business.4.19 PROSPECTSLeasing today accounts for six percent of the total capital investment in India.The 8th plan envisages capital formation of Rs. 8000 billion 50 per cent of which is totake place in the private sector. Leasing will playa significant role to account for atleast15 percent of gross capital formation.The world leasing industry grew at a rate of about 10 per cent. As the economyis opened up there will be substantial demand for a variety of leasing products suchas foreign currency leases, cross border leases, leverage leases etc. Leasing companiesset for substantial growth in line with international trends.Leasing has great prospects in India. It is on the threshold of a major breakthrough in industrial development due to liberalised economic policy measures initiatedby the government. Leasing as a convenient and flexible financing option can playavital role in the process of industrial development. The leasing industry has taken thecentre stage with the government and public sector undertakings are looking toindustry to finance railway, telecommunication, transport, power and infrastructuresectors. The infrastructure financing so crucial for an economic growth can not beaccelerated without leasing industry. The government has indicated that it is open tosuggestions for reviewing the existing policies. Such conduciveness and the willingnessto prevent bottlenecks in the area of taxation and other areas will go a long way inspeeding up the growth of the industry.4.20 SUMMARYLease is a contract whereby the owner of an asset (lessor) grants to anotherparty (lessee) the exclusive right to use the asset usually for an agreed period of timein return for payment of rent. Lease arrangement allows lessor to use equipment andpay for it from profits earned from its use.Leases are of four types; financial, operating, leverage and sale and lease back.Advantages of lease are alternative use of funds available to lessee; faster andcheaper credit, flexibility, protection against obsolescence etc.However, lease arrangements are not suitable for project finance, may not havetax incentives declared by the Government and normally cost more than debt financing.There isrno separate Act to regulate leases and they are governed by the section148 of the Contract Act on bailment. Lease rent paid by lessee is fully deductible for

tax purposes.Lease is accounted by lessor showing the asset on his balance sheet and claimingdepreciation and other tax shields on the asset. The lease rent is treated as incomein lessor's books and as expense in lessee's books.Both private and sectors provide lease finance.The leasingbusinesssuffersfrom unhealthycompetition, lackof qualifiedpersonnel,burden of sales tax as well as stamp duty, delays in payments including bad debts.4.21 SELF ASSESSMENT QUESTIONS'I. .r"I. T.ru~or,False:1. Infinancial lease, the contracts are cancellable either by the lessor or by thelessee.2. The average lease agreements involves three parties.3. Vendor leasing companies are formed to promote the sale of its parent companies.4. In house leasing companies are set up to avoid income tax liabilities of the groupcompanies.5. The lessee can claim investment allowance.[Key: 1.False, 2. True, 3. True, 4. True, 5. False]II. Fill in the Blanks:1. In financial lease, bears the risk of obsolescence.2. lease is for a limited period.3. The leased asset is shown on the Balance sheet of the _4. An equipment lease transaction is regarded as a contract of _5. The entire lease rental is treated as in the books of lessor.[Key: 1. lessee, 2. operating lease, 3. lessor, 4. bailment, 5. income]III. Short Answers:1. What is cross border lease?2. Write a note on 'Sale and Lease Back'3. What is vendor leasing?4. Define leasing.5. What is leverage lease?IV. Essay Type:1. Discuss the advantages and disadvantages of leasing.2. Explain the different kinds of leasing.3. Explain the structure of leasing industry in India.4. What are the problems of leasing in India.