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Lease Finance
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Leasing 2
Lease Finance
Lease is contract between the owner of the asset
(Lessor) and the user (Lessee) of the asset, wherein theLessor gives the right to use the asset to the Lessee for
a consideration (Lease Rentals) over an agreed period
of time (Lease period or tenure). At the end of the lease period, the leased asset reverts
back to the Lessor, unless the lease is renewed for
another term.
Leasing separates the Ownership and Usage of the
asset as two separate economic activities.
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Leasing 3
Leasing, Hire Purchase, Instalment Sale
Leasing:
Lessor retains the Ownership of the asset & claims thebenefit of Depreciation.
Lessee claims the Lease Rentals as tax-deductible
expense.
Hire Purchase: Ownership passes to the Hirer (user) on payment of the
last Instalment (on payment of Capital & Interest) and
takes benefit of Depreciation and tax-deductibility of the
Interest component of the Hire charges. Instalment Sale:
The legal ownership passes as soon as the 1stinstalment
is paid. The balance amount is treated as a secured loan
and Interest portion is Tax-deductible
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Leasing 4
Basic Types of Lease
On the basis of the extent to which the risks and
rewards incidental to the ownership of the leased
assets lie with the Lessor or the Lessee, lease can be
classified as:
Finance Lease
Operating Lease
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Leasing 5
Finance (or Capital) Lease
Non-cancellable for a specified period called the
PRIMARY LEASE Period- usually 5-8 years. Leased Asset is fully amortised over the Primary Lease
period subsequently the Lessor Charges nominal lease
rentals
Lessee is responsible for insurance & maintenance.
Risk of Obsolescence is shifted from the Lessor to the
Lessee.
E.g.: Leasing of Plant & Machinery
Financial lease transfers a major portion of the risks
assigned with ownership to the Lessee.
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Leasing 6
Operating Lease
Short-term Lease: Lease period is less than the
economic life of the asset. Asset leased is not fully amortised: Lease rentalsrequired to be paid under a lease agreement are notsufficient to recover fully the investment in the leased
asset. Lease is cancellable at short notice without substantialpenalty,
Lessor is responsible for the insurance & maintenanceof the asset.
Lessor bears the risk of obsolescence. E.g.: Taking a Taxi for travelling from one place to
anotherLessor retains most of the risks associated with the
ownership of the asset in case of Operating Lease.
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Other Types of Lease
Direct Lease: When a firm acquires the use of an asset, it did not
use previously.
The firm may obtain the asset on lease either from the
manufacturer or from a Leasing Company.
Leasing Company purchases the asset, as per the specification of
the firm and then lease it out to the firm.
Equipment Manufacturer(Lessor)
User Firm
(Lessee)
Leases
Equipment to
Equipment
Manufacturer
(Seller)
User Firm
(Lessee)
Leases
Equipment toLeasing
Firm
(Lessor)
Sells
Equipment to
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Other Types of Lease (Contd.)
Sale & Lease BackThe firm sells the asset to a leasing company
and then leases the same asset back to the firm.
Through Sale & Lease Back, the Firm is able to unlock its
investment in an existing asset, realises liquidity and at the same
time continues to enjoy the use of the asset.
Leasing
Company
(New Owner/Lessor)
User Firm
(Old Owner/Lessee)
Takes Back theEquipment on Lease
Sells
Equipment to
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Other Types of Lease (Contd.)
Leveraged Lease: From the Lessors point of view, a Lease could
be Leveraged or Non-Leveraged Lease. In a Leveraged Lease, besides the Lessor and the Lessee, there is
a third party (Financier), who finances the investment in the
leased asset.
Typically, a Lessor finances 80% of the cost of the asset by way ofa bank loan while contributing 20% towards the cost.
The loan is usually secured by the asset leased/ & by assignment
of the lease rentals.
Lessor is however entitled for the tax shields associated withownership of the asset.
From Lessees point of view, there is no difference between
Leveraged Lease & Non- Leveraged lease.
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Other Types of Lease (Contd.)
Big Ticket Lease :where the relative magnitude of investmentinvolved is high e.g.. Leasing of Aircrafts.
Dry Lease: Operating Lease where the Lessee bears the cost ofinsurance, maintenance, repairs. e.g.: Dry lease of Aircrafts by AIfrom SIA.
Wet Lease: Usual operating Lease i.e. Lessor bears the cost ofinsurance and maintenance repair.
Lease Line: A lease life is similar to a bank line of credit where theLessee is allowed to add on to the leased asset under the samebasic terms without negotiating a fresh lease every time a newequipment is leased. e.g.: Leasing of Bottles for beverages.
Upgrade Lease: Such Lease provides for automatic exchanges ofout-dated equipment with the latest version.
Sales-Aid Lease: Equipment manufacturer leases instead of sale.
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Lease Rental - Quote
Lease rentals are usually quoted as Rs. per month per thousand(PMPT) (or PQPT).
Lease rentals of Rs. 25 per month per Rs. 1000/- means that i.e.the Lessee will pay Rs. 25 every month for every Rs. 1000/- offunds borrowed.
If the asset cost is Rs. 40 Lacs, then the monthly lease rentalswould be :
Primary Lease period and Secondary Lease period
Besides, Lease rentals, upfront Lease management fees (say 1%of funds) is also charged.
40,00,00025 = Rs.1,00,000/-
1000
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Hire Purchase - Quote
Interest rate in case of Hire Purchase is quoted as a flat rate, say
12% for 3 years Hire Purchase contract. If the cost of asset takenon HP is Rs. 30 Lacs, then the Hire Purchase instalments wouldbe:
Total interest on Rs 30 Lacs @ 12% for 3 years = Rs.10,80,000
Hire Purchase instalments: Annual:
Monthly30,00,000 + 10,80,000
=Rs.1,13,333.3336
30,00,000 + 10,80,000=Rs.13,60,000.00
3
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Hire Purchase - Quote
Splitting of instalments into Interest & Principal repayment isbased on Sum-of-years-digits (SYD) method.
Yr Proportion Interest Installment Principal
Repayment
1 (36+35+34+.+25) /
(36+35++1)= 366/666
10,80,000*366/666
= 5,93,513.51
13,60,000.00 7,66,486.49
2 (24+23+22+.+13) /
(36+35++1)
= 222/666
10,80,000*222/666
= 3,60,000.00
13,60,000.00 10,00,000.00
3 (12+11+10+.+1) /
(36+35++1)
= 78/666
10,80,000*78/666
= 1,26,486.49
13,60,000.00 12,33,513.51
Total 10,80,000.00 40,80,000.00 30,00,000.00
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Flat rate of interest : 13%
No. of monthly instalments: 36
Down payment : 20%
Purchase Amount : Rs. 1000/- (assume)
Loan amount (80%) : Rs. 800/-
Total Interest : 800*0.13*3 = 312
Monthly Instalment : (800 + 312)/36 = Rs. 30.89
14
Hire Purchase - Effective Interest rate
Month 0 1 2 3 . 34 35 36
Loan -800Instalments +30.89 +30.89 +30.89 +30.89 +30.89 +30.89
Total CFs -800 +30.89 +30.89 +30.89 +30.89 +30.89 +30.89
Case 1: Instalments paid in arrears:
IRR of Cash Flows: 0.01901 or 1.901%
Effective Interest rate (on Annual basis) = (1+0.1901)12 - 1 = 25.35%
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Hire Purchase - Effective Interest rate
Case 2: Instalments paid in advance:
IRR of Cash Flows: 0.02025 or 2.025%
Effective Interest rate (on Annual basis) = (1+0.02025)12 - 1 = 27.21%
Month 0 1 2 3 . 34 35 36Loan -800
Instalments +30.89 +30.89 +30.89 +30.89 +30.89 +30.89
Total CFs -769.11 +30.89 +30.89 +30.89 +30.89 +30.89
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Hire Purchase - Effective Interest rate
Case 3: Depositwith Instalments paid in arrears:
IRR of Cash Flows: 0.02304 or 2.304%
Effective Interest rate (on Annual basis) = (1+0.02304)121 = 31.47%
Flat rate of interest : 13%
No. of monthly instalments: 36
Deposit : 20%
Interest on Deposit : 15% pa (compounded monthly)
Purchase Amount : Rs 1000/- (assume)
Loan amount : Rs. 1000/-
Total Interest : 1000*0.13*3 = 390 Monthly Instalment : (1000 + 390)/36 = Rs. 38.61
Month 0 1 2 3 34 35 36
Loan -1000Instalments +38.61 +38.61 +38.61 +38.61 +38.61 +38.61
Deposit +200 -312.79
Total CFs -800 +38.61 +38.61 +38.61 +38.61 +38.61 -274.18
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Hire Purchase - Effective Interest rate
Case 4: Deposit with Instalments paid in advance:
IRR of Cash Flows: 0.02541 or 2.541%
Effective Interest rate (on Annual basis) = (1+0.02541)12 - 1 = 35.14%
Summary - Effective Interest rate
Month 0 1 2 3 34 35 36
Loan -1000
Instalments +38.61 +38.61 +38.61 +38.61 +38.61 +38.61
Deposit +200 -312.79
Total CFs -761.39 +38.61 +38.61 +38.61 +38.61 +38.61 -312.79
Instalments in Arrears Instalments in Advance
Down payment 25.35% 27.21%
Deposit 31.47% 35.14%
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Lease Evaluation
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Lease Evaluation
ABCL has identified an equipment costing Rs. 10 Lacs with an
expected useful life of 8 years. The equipment shall increase the
earnings (EBDIT) by Rs. 3 Lacs pa. The equipment is eligible for
depreciation @ 25% pa on WDV basis and expected to be sold as
scrap at its book value. First Leasing Company can provide the
equipment on an 8-year lease @ Rs.1.75 Lacs pa, payable in arrears.
The companyspost-tax cost of capital is 10%. Assume the tax rate
as 35%.
Evaluate the lease proposal.
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Lessees view point
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Lessees view point
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If NAL > 0, then Lease, provided NPV(P) is also > 0.
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Lessees view point
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Lessors view point
25
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Lease Evaluation
VXL Limited requires an equipment costing Rs. 40 Lacs. The
equipment is expected to increase its annual revenues by Rs. 30
Lacs besides increasing the operating costs (other than depreciation
& interest) by Rs. 8 Lacs. The salvage value expected after 5 years
(its useful life) would be Rs. 4 Lacs. The companysD/E ratio is 1:1,
cost of debt is 14% and cost of equity is 20%. Assume the tax rate as
50% and depreciation rate as 33.33% (WDV basis).
Axis Bank can provide lease finance for a 5-year period @ Rs. 70.50
per quarter per Rs.1000/-, payable quarterly in advance.
Evaluate the lease proposal from VXL Limitedspoint of view.
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Leasing 28
Lessees view point
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Leasing 29
Lease EvaluationLessees view point
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Leasing 30
Lessees view point
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Leasing 31
Lease EvaluationLessees view point
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Leasing 32
Lease EvaluationLessees view point
(1+rq)4=1.16
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Leasing 33
Lease EvaluationLessees view point
PVIFA @
3.7802%
0 1.00001 0.9636
2 0.9285
3 0.8947
4 0.8621
5 0.8307
6 0.8004
7 0.7713
8 0.7432
9 0.7161
10 0.6900
11 0.6649
12 0.6407
13 0.617314 0.5948
15 0.5732
16 0.5523
17 0.5322
18 0.5128
19 0.494114.3826
AD n
1 1PVIFA = - (1+r)
r r(1+r)
20
1 1- (1.037802)=14.3826
0.037802 0.037802(1.037802)
l i i
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Leasing 34
Lease EvaluationLessors view point
l i i i
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Leasing 35
Lease EvaluationLessors view point
L E l i L i i
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Leasing 36
Lease EvaluationLessors view point
L E l i L i i
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Leasing 37
Lease EvaluationLessors view point
Weighted Average Cost of Capital (WACC)
Cost of Debt 12%
Cost of Equity 17%
D/E 2.5 :1
Tax Rate 50%
WACC 9.14%
PVIFA @
2.21%
0 1.0000
1 0.9784
2 0.9572
3 0.9365
4 0.9162
5 0.8964
6 0.8770
7 0.8580
8 0.8395
9 0.8213
10 0.8035
11 0.7862
12 0.7692
13 0.7525
14 0.7362
15 0.7203
16 0.7047
17 0.6895
18 0.6746
19 0.6600
PVIFA 16.3772
L E l i L Vi
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Leasing 38
Lease EvaluationLessees View
n
t t n
t nt=1
X (1-T)+D T S
NPV(P)=-A+ +(1+k) (1+k)n n
t t t
t tt=1 t=1
X (1-T)+L T L
NPV(L)= -(1+k*) (1+k*)
NPV(L)-NPV(P)=NAL
(assume k = k*)n
t t
t
t=1
X (1-T)-L (1-T)=
(1+k*)
L l i L Vi (C d )
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Leasing 39
Lease EvaluationLessees View (Contd.)
n n nt t t t t n
t t t nt=1 t=1 t=1
X (1-T)+L T L X (1-T)+D T SNAL= - - -A+ +
(1+k) (1+k) (1+k) (1+k)
Case 1: Lease Rentals paid Yearly in arrears
n n n n n
t t t t t nt t t t t n
t=1 t=1 t=1 t=1 t=1
X (1-T) L T L X (1-T) D T S= + - +A- - -(1+k) (1+k) (1+k) (1+k) (1+k) (1+k)
n nt t n
t t nt=1 t=1
L (1-T) D T SNAL=A- - -
(1+k) (1+k) (1+k)
Asset
CostPV of Post Tax Lease
Rentals
PV of Depreciation Tax
Shield
PV of Salvage
Value
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Lease vs. Hire Purchase
L Hi P h
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Lease 46
Lease vs. Hire Purchase
Lease:Lease Rentals Outflow
Tax Shield on Lease Rentals Inflow
Or Post tax Lease Rentals Outflow
Hire Purchase:
Interest portion of HP Instalments Outflow
Tax Shield on Interest portion Inflow
Or Post tax Interest portion of HPinstalments
Outflow
Principal Repayment Outflow
Depreciation Tax Shield Inflow
Salvage Value Inflow
L Hi P h
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Lease 47
Lease vs. Hire Purchase
Axis Bank offers a hire purchase proposal to Ajanta Tyres Ltd in
respect of an equipment costing Rs. 5 Lacs at a flat rate of 12% for a
period of 3 years. The bank may also provide lease finance for the
equipment for a Primary lease period of 5 years during which the
lease rentals would be Rs. 300 per Rs. 1000 per year. The secondary
lease period would be for 5 years with secondary lease rentals of
Rs. 10,000/- per year. The equipment is eligible for depreciation@ 33.33% (WDV basis) and the expected salvage value at the end of
10 years would be Rs. 50,000/-. Ajanta Tyres can borrow funds
@ 16% while the tax rate is 35%.
Should Ajanta Tyres take the equipment on Lease or Hire Purchase?
L Hi P h
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Lease 48
Lease vs. Hire Purchase
Lease s Hire P rchase
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Lease 49
Lease vs. Hire Purchase
Interest * SYD%
Lease vs Hire Purchase
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Lease 50
Lease vs. Hire Purchase
Lease vs Hire Purchase
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Lease 51
Lease vs. Hire Purchase
As the cost of Lease option is higher than Hire purchase option,
taking the equipment on Hire purchase is preferable.
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Lease vs. Buy
Lease Evaluation Lessees view point
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Lease 53
Lease EvaluationLessee s view point
SaiTel Solutions Limited has shortlisted a new computer systemwhich shall cost Rs. 300 Lacs to buy. The asset shall depreciate on
SLM basis over its useful life of 3 years. The company has beenapproached by a leasing company to provide the equipment on an3year lease with lease rentals of Rs. 110 Lacs per year (end of theyear). The tax rate for the company is 30% and its WACC is 15%.
Should the company take the equipment on lease?
Lease Evaluation Lessees view point
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Lease EvaluationLessee s view point