PRESENTATION ON LEASE FINANCING

Introduction
The main objective of the business is to maximise the owner s economic welfare. The firm makes investments to maximise stockholder s wealth. After identifying attractive projects, the firm to debt and equity financing, leasing has emerged as a third important source of intermediate and long term financing of corporate financing during recent few decades. It is widely used in western countries to finance investments. Prior to 1950, leasing was primarily concerned with real estate i.e. land and building. But today, almost all types of fixed assets can be leased.

Meaning
Leasing is an arrangement that provide a firm with the use and control over assets without buying and owing the same. It is the form of renting the assets. Lease is the contract between the owner of the asset (lessor) and the user of the asset called the lessee, whereby the lessor gives the right to use the asset to the lessee over an agreed period of time for a consideration called the lease rental. The lease contract is regulated by the terms and conditions of the agreement. The lessee pays the lease rent periodically to the lessor as the regular fixed payments over a period of time. The rentals may be payable at the beginning or end of the month, quarter, half-year or year. At the expiry of the lease period, the asset reverts back to the lessor who is the legal owner of the asset.

In the words of MILLER, M.H. and C.W. UPTRON-

Leasing separates ownership and use as two economic activities, and facilitates the asset use without ownership .

Types of leasing
There are two basic kinds of leasing:

Leasing

Operating or Service Lease

Financial Lease

1. Operating Or Service Lease

An operating lease is characterised by the following features:

a) It is a short term lease on a period to a period basis. The lease period in such a period is less than the useful life of the asset. b) The lease is usually cancellable at the short term by the lessee. c) As the operating period is less than the useful life of the asset, it does not necessarily amortize the original cost of the asset. The lessor has to make further leases or sell the asset to recover his cost of investment and expected rate of return. d) The lessee has usually the option of renewing the lease after the expiry of lease period. e) The lessor is generally responsible for maintenance, insurance and taxes of the assets. He may also provide other services to the lessee. f) As it a short term cancellable lease, it provides higher risk to the lessor but higher lease rentals to the lessee.

2. Financial Lease
A lease is classified as a financial lease if it ensures the lessor for amortization of the entire cost of the investment plus the expected return on the capital outlay during the term of the lease. Such a lease is usually for a longer period and non cancellable. As a source of funds, the financial lease is an alternative similar to debt financing. Most of the leases in India are financial leases the tare commonly used for leasing land, building, machinery and equipments etc.

A financial lease is usually characterised by the following features:

a) The present value of the total lease rentals payable during the period of the lease exceeds or is equal to substantially the whole of the fair value of the leased asset. It implies that within the lease period, the lessor recovers his investment in the asset and the expected rate of return. b) As compared to operating lease, the financial lease is for longer period.

c) It is usually non cancellable by the lessee prior to its expiration date.

d) The lessee is generally responsible for the maintenance, insurance and service of the asset. However, the term of the lease agreement, in some cases may require the lessor to maintain and service the asset. Such an agreement is called maintenance or gross lease . But usually in operating lease, it is the lessee who pays for maintenance and service cost and such a lease in known as net lease . e) A financial lease usually provides the lessee with an option of renewing the lease for further period at a nominal rate.

Forms of Financial Lease

The following are the forms of financial lease arrangements:

1)

Sale And Leaseback

A sale and leaseback arrangement involves the sale of the asset already owned by the firm (vendor) and leasing of the same asset back to the vendor from the buyer. This form of lease arrangement enables the firm to receive cash from sale of asset and also retain the economic use of the asset in consideration of the periodic lease payments. A sale and lease back arrangements is generally preferred by a firm facing shortage of working capital funds.

2)

Direct Leasing

In contrast with sale and leaseback, under direct leasing a firm acquires the use of the asset that is not already own, a direct lease may be arranged either from the

manufacturer supplier directly or through the leasing company. In the first case, the manufacturer/supplier himself acts as the lessor while the second case the lessee firm arranges the purchase of the asset for the leasing company (lessor) from the manufacturer or the supplier and also enters into an agreement with the lessor for the lease of the asset.

3)

Leveraged Lease

A leveraged lease is an arrangement under which the lessor borrows funds, for purchasing the asset, from third party called lender which is usually a bank or a finance company. The loan usually secured by the mortgage of the asset and the lease rentals to be received from the lessee. The loan is paid back out of lease rentals, may be directly by the lessee by paying only the excess amounts to the lessor. The lessor acts as the owner as the borrower and the lender is usually a bank, insurance company, financial institution or a private financing company.

4)

Straight Lease And Modified Lease

Straight lease requires the lessee firm to pay lease rentals over service life of the asset and does provide for any modifications to the terms and conditions of the

basic lease. Modified lease, on the hand, provides several options to the lessee during the lease period. For example, the options of terminating the lease may be providing by either purchasing the asset or returning the same.

5)

Primary And Secondary Lease

Under primary and secondary lease, the lease rentals are charged in such a manner that the lesser recovers the cost of asset and acceptable profit during the initial period of the lease and then secondary lease is provided at nominal rentals.

Mechanics of leasing
As a financial manager who is evaluating of leasing, you should know the following:
1) 2) 3) 4) 5) 6) Legal aspects of leasing Typical contents of leasing Income tax provisions relating to leasing Sales tax provisions relating to leasing Procedural aspects of leasing Accounting treatment of leases

1.

Legal Aspects Of Leasing

As there is no separate statute for equipment leasing in India, the provisions relating to the bailment in the Indian Contract Act govern equipment leasing agreements as well. Section 148 of the Indian Contract Act defines bailment as: The delivery of goods by one person to another, for some purpose, upon a contract that they shall, when the purpose is accomplished, be returned or otherwise disposed off

according to directions of the persons delivering them. The person delivering the goods is called bailer and the person to whom the goods are delivered is called the bailee . Since an equipment lease transaction is regarded as a contract of bailment, the obligation of the lessor and the lessee is similar to those of the bailer and the bailee (other than those specified in the lease contract) as defined by the provisions of section 150 and 168 of the Indian Contract Act. Essentially these provisions have the following implications for the lessor and the lessee: 1) The lessor has the duty to deliver the asset to the lessee, to legally authorise the lessee to use the asset, and to leave the asset in peaceful possession of the lessee during the currency of the agreement. 2) The lessee has the obligation to pay the lease rentals as specified in the lease agreement, to protect the lessor s title, to take reasonable care of the asset, and to return the lease asset on the expiry date of the lease period.

2. Typical Contents Agreement

Of

The

Lease

The lease agreement specifies the legal rights and obligations of the lessor and the lessee. It typically relates the term to the following: i. ii. iii. iv. v. Description of the lessor, the lessee and the equipment. Amount, time and place of lease rental payments. Time and place of the equipment delivery. Lessee s responsibility of taking the delivery and possession of the leased equipment. Lessee s responsibility for maintenance, repairs, registrations, etc. and the lessor are right in case of default by the lessee. Lessee s right of enjoying the benefit of warranty provided by equipment manufacturer. Insurance to be taken by the lessee on behalf of the lessor. Variation in lease rentals if there is a change in certain external factors like bank interest rates, depreciation rates, and fiscal incentives. Option of lease renewal for the lessee.

vi. vii. viii.

ix.

3. Income Tax Provisions Relating To Leasing

The principles of income tax relating to the leasing are as follows:
1) The lessee can claim lease rentals as the tax-deductable expenses. 2) The lease rentals received by the lessor are taxable. 3) The lessor can claim depreciation on investment made in leased assets.

4.

Sales Tax Provisions Relating To Lease

1) The lessor is not entitled for the concessional rate of central sales tax because the asset purchased for leasing is meant neither for resale nor for use in manufacture. 2) The 46th Amendment Act has brought lease transactions under the purview of sale and has empowered the central and state governments to levy sales tax on lease transaction.

5.

Procedural Aspects

The procedure involved in a lease arrangement consists of the following:

1) The lessee selects the equipment. This involves specification of the equipment, supplier, price, and term of warranties, delivery period, installation and the service. 2) The lessee approaches the lessor. Submits a formal application, and negotiates the term of lease. 3) The lessee and the lessor sign the lease agreement. 4) The lessee assigns the purchase rights to the lessor and the lessor purchases the equipment which delivered to the lessee. 5) The lessee insures the equipment and endorses the insurance policy in favour of the lessor.

Financial Evaluation of Leasing

Financial viability of the lease can be evaluated separately (I) from the point of view of the lessee, and (ii) from the point of view of the lessor.

A.

Lessee s point of view

Lease or buy/lease borrow decisions

Once a firm has evaluated the economic viability of an asset as an investment and accepted/selected the proposal, it has to consider alternate methods of financing the investment. However, in making an investment, the firm need not own the asset. It is basically interested in acquiring the use of the asset. Thus, the firm may consider leasing of the asset rather than buying it. In comparing the leasing with buying, the cost of leasing the asset should be compared with the cost of financing the asset through normal sources of financing, i.e. debt and equity.

The evaluation of the lease financing decisions from the point of view of the lessee involves the following steps: I. II. III. Calculate the net present value of net-cash of the buying option, called NPV (B). Calculate the net present value of net-cash of the leasing option, called NPV (L). Decide whether to buy or lease the asset or reject the proposal altogether by applying the following criterion: If NPV (B) is positive and greater than NPV (L), purchase the asset. If NPV (L) is positive and greater than NPV (B), lease the asset. If NPV (B) as well as NPV (B) are both negative, reject the proposal altogether.

IV. V. VI.

Since many financial analysts argue that the lease financing decisions arise only after the firm has made an accept-reject decision about the investment; it is only the comparison of the cost of leasing and borrowing options. The following steps are involved in such an analysis: (i) Determine the present value of after tax cash outflows under the leasing option. (ii) Determine the present value of after tax cash outflows under the buying and borrowing option.

(iii) Compare the present value of cash outflows from leasing option with that of buying/borrowing option. (iv) Select the option with lower presented value of aftertax cash outflows.

B.

Lessor s Point Of View

The financial viability of leasing out an asset from the point of view of lessor can be evaluated with the help of the two adjusted methods of capital budgeting:

a) b)

Present Value Method Internal Rate of Return Method

a)

Present Value Method:-

This method involves the following steps:

(i) Determine cash outflows by deducting tax advantage of owning an asset, such as investment allowance, if any (ii) Determine cash inflows after-tax as below:
Rs. Lease rental (say) Less: Depreciation (say) Earnings before Tax (EBT) Less: Tax (say 50%) Earnings after Tax (EAT) Add: Depreciation Cash Inflows after Tax (CFAT) 1, 00,000 20,000 80,000 40,000 40,000 20,000 60, 000

(iii) Determine the present value of cash outflows and after tax cash inflows by discounted at weighted average cost of capital of the lessor.

(iv) Decide in favour of leasing out an asset if present value of cash inflows exceeds the present value of cash outflows, i.e., if the NPV is +ve ; otherwise in case NPV is ve, the lessor would lose on leasing out the asset.

(b) Internal Rate of Return Method

The internal rate of return can be defined as that rate of discount at which the present value of cash inflows is equal to the present value of cash outflows. It can be determined with the help of the following mathematical formula:

A1 (1 + r)

A2

A3

..+ An (1+r) n

(1 + r) 2

(1 +r) 3

C A1, A2....An 2, 3 r ..n

= = = =

Initial outlay at time zero future net cash flows at different periods. numbers of years rate of discount of internal rate of return.

The internal rate of return can also be determined with the help of present value tables. The following steps are required to practice the internal rate or return method:

1. Determine the future net cash flows for the period of the lease. The net cash inflows are estimated future net cash flows for the period of the lease. The net cash inflows are estimated future earnings, from leasing out the asset, before depreciation but after taxes. 2. Determine the rate of discount at which the present value of cash inflows is equal to the present value of cash outflows .This may be determined as follows:

a) WHEN THE ANNUAL NET CASH FLOWS ARE EQUAL OVER THE LIFE OF THE ASSET:
Firstly, find out Present Value Factor by dividing initial outlay (cost of investment) by annual cash flow, i.e.
PRESENT VALUE FACTOR = Initial Outlay Annual Cash Flow

Then, consult present value annuity tables with the number of year equal to the life of the asset and find out the rate at which the calculated present value factor is equal to the present value given in the table.

b) WHEN THE ANNUAL CASH FLOWS ARE UNEQUAL OVER THE LIFE OF THE ASSET:
In case annual cash flows are unequal over the life of the asset. The internal rate of return cannot be determined according to the technique suggested above. In such case, the internal rate of return is calculated by hit and trial and that is why this method is also known as hit and trial yield method. We may start with assumed discount rate and find out the total present value of all the cash flows by consulting present value tables. The so calculated total present value of cash inflows as compared with the present value if cash outflows which is equal to the cost of the initial investment where total investments is to be made in the beginning. The rate which the total present value of all cash inflows equal the initial outlay, is the internal rate of return. The calculation process may be as follows:

i.

ii.

iii. iv.

v.

Prepare the cash flow table using the arbitrary assumed discount rate to discount the net cash flow to the present value. Find out the Net Present Value by deducting from the present value of total cash flows calculated in above initial cost of the investment. If the NPV is positive, apply higher rate of discount. If the higher discount rate still gives a positive net present value, increase the discount rate further until the NPV becomes negative. If the NPV is negative at this higher rate, the internal rate of return must be between these two rates.

3. Accept the proposal if the internal rate of return is higher than or equal to the minimum required rate of return i.e. the cost of capital or cut off rate. 4. In case of alternative proposals select the proposal with the highest rate of return as long as the rates are higher than the cost of capital or cut off rate.

Methods of Computing Lease Rentals

The following steps are involved in computing the lease rentals:

1) Determine the cost of asset which includes the actual purchase price and expenses like freight, insurance, taxes and installation, etc. 2) Determine the cash flows to the lessor on account of ownership of the asset. These include tax advantage provided by depreciation and investment allowances.

3) Calculate the present value of net cash flow as determined in step 2. 4) Subtract the present value of cash flows of ownership advantage from the cost of the asset determined in step 1 so as to determine minimum required net recovery through lease rentals.

5) Calculate the post-tax lease rentals by dividing the minimum required net recovery through lease rentals by present value factor of annuity. 6) Compute the pre-tax lease rentals by adjusting the posttax lease rentals for tax factor.

Economics/Pros and Cons of Leasing

Despite the fact that leasing is generally more expensive for the lessee and involves a high risk for the lessor, it is an arrangement whereby both the lessee and the lessor stand to gain. There are various considerations that make leasing attractive for both the lessee as well as the lessor.

Advantages of Leasing To the Lessee

i) Avoidance of the Initial Cash Outlay.
Leasing enables a firm to acquire the use of an asset without making capital investment in buying the asset. The lessee may avail 100% finance from lease financing and avoid even initial investment in margin money as required under loan financing. However, some leasing companies demand that first lease rent should be paid in advance.

ii) Minimum delay

Usually, leasing companies take much lesser time in processing the lease proposal as compared to the lengthy procedure as involved in the term loan financing. Thus; a firm can avoid delay in the use of an asset by taking it on lease.

iii) Easy source of finance

Leasing provides one of the easiest sources of intermediate and long-term financing. It does not require any mortgage of assets because the owner ship of assets leased remained with the lessor and is transferred to the lessee. Moreover, various restrictive provisions imposed in term loan financing are avoided . The initial cost of rising the finance through leasing is also much lesser then that of raising long-term debt.

iv) Shifting the risk of obsolescence

In the present era rapid changes technologies, a firm has to bear the risk of obsolescence if it purchases the asset. The firm (lessee) can easily shift this risk upon the lessor by acquiring the use of the asset on the lease rather than buying the same.

v) Tax planning and differential tax advantage

As the rentals are considered as a revenue expense while determining taxable profits, it is advantageous to the lessee in minimising tax liabilities. Moreover, the lessor who is usually in the higher tax bracket passes on the benefit of depreciation advantage to the lessee in the form of reduced lease payments. The lessee can also arrange to adjust lease rentals in such a way that if it reduces his tax liability and thus helps him in tax planning.

Limitations of Leasing For Lessee

i) Higher cost
The lease rentals include a margin for lessor as also the cost of risk is obsolescence. It is, thus, regarded as a form of financing at higher cost.

ii) Loss of moratorium period

The lease rentals do not care of the gestation period. It usually takes a long time before the assets generates funds to pay it back. The term loan provides certain moratorium period in repayments for that reason. But no such moratorium is permitted under lease agreements.

iii) Risk of being deprived of the use of asset

The lessee may be deprived of the use of asset due to the deterioration in the financial position of the lessor or winding up of the leasing company.

iv) No alteration or change in asset

As the lessee is not the owner of the asset, he cannot make substantial changes in the asset. Contrary to it, in case of outright purchase the buyer can modify or alert the asset to increase its utility.

v) Loss of ownership incentives

There are certain advantages of owing the assets, such as depreciation and investment allowance, in case of lease; the lessee is not entitled to such benefits.

Advantages of the Leasing To the Lessor

1.

Higher profits

The lessor acting prudently can make high profits from leasing of the asset. The profits will take care of his cost of capital as well as the risk involved.

2.

Tax benefits

The lessor being the owner of the asset can claim various tax benefits such as depreciation, investment allowance, etc. In fact, leasing has been successfully employed by the leasing companies to reduce their tax liabilities.

3.

Quick return

The lessor gets quick return in the form lease rentals as compared to investment in other rejects which have a longer gestation period.

4.

Increased sales

Lease financing through third parties has helped manufacturers to increase their sales. The lessors are also in a position to demand certain concessions from the manufacturers.

Limitations for the Lessor

1. High risk of obsolescence

The lessor has to bear the risk of obsolescence especially in the present era of rapid technology developments.

2.

Competitive market

As a number of leasing companies have emerged in recent years in India, the lessor has to face a tough competition from Indian as well as foreign companies. Due to this competition, the lessor may not be able to obtain sufficient ease rentals to recover the cost of the asset and his expected profit on investment as well as taking the risk.

3.

Management of cash flows

The success of leasing business depends to a large extent upon efficient the use cash flows which are very difficult to manage because of unexpected market fluctuations.

4. Increased cost due to loss of user benefits

The lessor is not entitled to certain benefits available to buyers who are actual users of the assets such as concession in sales tax, duties etc. This increases the cost of asset and compels the lessor to charge higher lease rentals.

5.

Long-term investment

It usually takes a long time to recover the cost of the lessor in the capital outlays through lease rentals. Thus, lease rentals received may not represent actual realised profits because of inherent risks involved. Payment of dividends out of present earning may ultimately result into payment out of capital.