CMA. CHANDER DUREJA [9811981369] LORD KRISHNA COMMERCE ACADEMY 7.

Leasing Decision

Chapter Overview

Leasing – Conceptual Framework Write Hours taken for study

1. Leasing – Meaning 1. First Study
2. Finance Lease vs Operating Lease 2. Revision 1
3. Sale and Lease Back, and Sales Aid Lease 3. Revision 2
4. Leveraged Lease 4. Revision 3
5. Advantages of Lease
6. Disadvantages of Lease
7. Structuring of Lease Rentals
8. Cross Border Leasing and Defeasing

1. What is Leasing? What are the characteristic features of Financial and Operating Lease?
Leasing:
#Leasing is a contract where one party. (Owner / Lessor / Leasing Company) purchases the assets and permits its use
by another party (Lessee) over a specified period of time. Thus, Leasing is an alternative to the purchase of an asset
out of own or borrowed funds.
#Leasing is the renting out of an asset by the Owner, to a person for a recurring consideration (called Lease Rentals)
payable over the period of tenancy.

Types: Lease may be classified into (a) Operating Lease, and (b) Financial Lease, the major points are as under –

Particulars Finance Lease Operating Lease

A Finance Lease is an arrangement to A lease is classified as an Operating Lease,
1. Meaning finance the use of equipment for a major if it does not secure for the Lessor the

part of its useful life. It is also called recovery of capital outlay plus a return on
Capital Lease, as it is nothing but a loan the funds invested, during the lease term.
in disguise.
Compared to an Operating Lease, a The term of Operating Lease is shorter
2. Term FinancialLease is longer – termin nature. than the asset's economic life.

Risks and Rewards incident to ownership The Lessee is only provided the use of the
3. Risk and Rewards arepassed on to the Lessee. The Lessor asset for a certain time. Risk incident to
only remains the legal owner of the asset. ownership belong wholly to the Lessor.
All risks (including Obsolescence Risk)
4. Obsolescence Lessee bears the risk of obsolescence.
incidental to ownership belong wholly to

the Lessor.
Lessor is interested in his rentals and not As the Lessor does not have difficulty in

5. Right to cancel in the asset. He must get his principal leasing the same asset to any other willing
back along with interest. So, the lease is Lessor, the lease is kept cancellable by the

generallynon – cancellableby either party. Lessor.

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Lessorenters into the transaction only Usually, theLessorbears cost of

6.Cost of Repairs, etc.
asFinancier. He does not bear the cost of repairs,maintenance or operations.
repairs, maintenance or operations.
The lease is usually full pay – out, that is, The lease is usually non – payout, since
7. Full pay – out the single lease repays the cost of the the Lessor expects to lease the same asset

asset together with interest thereon. over and over again to several users.
The variants under Finance Lease include –
 Lease with Purchase Option, i.e. where the Lessee has the right to purchase the leased assets, after the
expiry of initial lease period at an agreed price.
 Lease with Lessee having Residual Benefits, i.e. where the Lessee has the right to share the sale
proceeds of the asset after expiry of initial lease period and/or to renew the lease agreement at a lower
rents
2. Explain the concepts of - (1)Sale and Lease Back, and (2) Sales Aid Lease.
1. Sales and Lease Back:

a. Here, the owner of an asset sells the asset to a party (Buyer), who in turn leases back the same
asset to the owner in consideration of Lease Rentals. So, the asset is not physically exchanged,

but is transferred by way of BookEntries only.

b. In this transaction, the Seller assumes the role of Lessee and the Buyer assumes the role of Lessor.

The Seller gets the agreed Selling Price and the Buyer gets the Lease Rentals.
c. The main advantage is that the Lessee can satisfy himself completely regarding thequality of the

asset, and afterpossession of the asset, convert the sale into a lease agreement.
2. Sales – AidLease:

a. Under this lease contract, the Lessor enters into a tie up with a Manufacturer (of Equipment /
Assets) for marketing the latter's product through his own leasing operations, it is called a Sales –

Aid – Lease.
b. In consideration of the aid in sales, Manufacturers may grant either credit, or a commission to the

Lessor. Thus, the Lessor earns from both sources, i.e. from the Lessee and the Manufacturer.
3. Explain the concept of Leveraged Lease.
1. Under a Leveraged Lease arrangement, the Lessor (either an individual Entity, or a Group of a Equity
Participants) borrows substantial portion of the purchase price of the Asset from a Lender, i.e. a
Commercial Bank or a Financial Institution, with full recourse to the Lessee without recourse to the Lessor.
2. The Lease Agreement provides for the Lease Rentals to the paid b by the Lease and creation of mortgage
/ charge on the asset, in favor of the Lessor.
3. The transaction is routed through a Trustee who looks after the interest of the Lessor and the Lender.
4. The Trustee receives the rentals from the Lessee and passes on to the Lender, and the surplus left after
satisfying the claims of the Lender, goes to the Lessor.

5. As owner of the asset, the Lessor is entitled to tax benefits by claim of Depreciation Allowance.
 CMA. CHANDER DUREJA [9811981369] LORD KRISHNA COMMERCE ACADEMY 7.3

4. List the advantages of a leasing transaction, from the Lessor's perspective as well as from the Lessee’s
perspective.

Advantages to Lessor:
Full Security: Lessor's interest is fully secured as he is always the owner of the asset and can take repossession of the
asset, if the Lessee defaults.

Tax Benefits: Tax Relief is available by way of depreciation. Generally, Leased Assets carry a higher depreciation rate.
If the Lessor is in high tax bracket, he can lease out assets with high depreciation rate, and thus reduce his tax
liability substantially. Also, Lease Rentals can be suitably structured to create valid tax benefits to the Lessor.

High Profits: Due to a higher depreciation charge, there is a quicker capital recovery and also higher profitability
since rate of return is more what is available in case of lending business.

Trading on Equity: Lessors have very low equity and use substantial amount of Borrowed Funds and deposits
fortheir business. Thus, they carry out their operation with high Financial Leverage. Hence, ROE is very high.

Advantages to Lessee:
100% Financing: Lease Financing may be available upto 100% of Asset cost, without making any Down Payment or
Margin Payment.

No dilution of Ownership: Leasing provides finance without diluting the ownership or control of the Promoters,
unlike Equity or Debt financing.

Less Risk: Risk of Obsolescence rests with the Lessor, particularly in Operating Lease. The Lessee has the option of
replacing the asset with latest technology, by opting for a different asset or Lessor.

Sale and Leaseback: By employing sale and lease back arrangement, the Lessee may overcome a financial crisis by
immediately arranging financial resources.

No Loss of Control: Institutional Financing (Bank and Other Term Lending Institutions) may have restrictive
covenants, e.g. representation in the Board, conversion of Debt into Equity, payment of Dividend, time – consuming
documentation formalities, etc. Lease Financing does not have these restrictions and have comparatively less
documentation aspects. This enhances the independence of the Firm in its operations.

Tax Benefits: Since the entire lease rental is treated as an expenditure, cost of the asset is amortized rapidly under
this option, and hence there is huge tax savings, when compared to similar outflow under borrow and procure
option. Also, benefits may accrue to the Lessee based on suitable scheming of Lease Rentals.

Small Value Assets: Piecemeal Financing of small equipments is conveniently possible through lease arrangement
only, as debt financing for such items is impracticable.
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. This
neither affects the Debt Equity Ratio or the Current Ratio of the Lessee.

5. Leasing is not without its shortcomings. Discuss.

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

b. Cost:In case of default by Lessee, it leads to heavy damage to the Lessor, by way of cancellation
of lease, finding another suitable buyer / lessee for using the Asset, etc.
2. Disadvantages to Lessee:
a. Restrictions on Use: The Lessor generally imposes certain restrictions on the Leased Assets. The

Lessee may not be permitted to make additions on alterations to suit his needs. Also, the Seller's
warranties for satisfactory operation of the leased assets may sometimes not be available to
Lessee.
b. No Ownership: In most circumstances, the Lessee does not become the owner of the asset, and

is thus deprived of the Residual Value of the asset.

c. High Cost: Lease Financing has a very high cost of interest as compared to interest charged on
Term Loans by Financial Institutions/Banks.

d. No Moratorium: Lease Rentals become payable soon after the acquisition of assets and no
moratorium period is permissible as in case of Term Loans from Financial Institutions. So, the
lease arrangement may not be suitable for new projects, since it would entail Cash Outflows even
before the project comes into operation.

e. Understatement of Lessee's Assets: Leased Assets are not considered Lessee's Assets, and
therefore, they do not appear in the Balance Sheet of the Lessee as an asset. To this extent, the
Assets of the Lessee's business would be understated.
f. Double Sales Tax: With the imposition of Sales Tax on Lease Transactions by various states, the

assets are subject to Sales Tax, both when Lessor purchases (from the Lessee himself or from
some other party), as well as when he leases it to the Lessee.
g. Default by Lessor: If the Lessor obtains credit facilities from Banks, etc. to purchase the leased
equipment, three will be a hypothecation charge in favour of the Bank. Default in payment by the
Lessor may sometimes result in seizure of assets by Banks, causing loss to the Lessee.
h.
6. What are the different methods of structuring a Lease Rental?
Structuring of a Lease Rental refers to the determination of the timing and the amount of Lease Rentals. Lease
Rentals can be of the followingtypes, to enable the Lessee to pay from the funds generated from its operations –
1. Equal Annual Plan: Here, the Lease Rentals are charged equally throughout the period of the Lease.
2. Deferred Lease Rentals: Here, the Rentals are structured with a moratorium for an agreed initial period,
so that the Lease Rental can be paid as and when funds are generated from the operations of the Lessee.

3. Stepped up Lease Rentals: Here, there is a constant rate of increase in the amount of Lease Rentals
charged throughoutthe period of Lease.
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4. Balloon Lease Rentals: Here, the Lease Rent is kept low initially, and increases along with Cash Flows
generated by the Lessee from his operations, e.g. if profits from the Leased Plant start from the 3 rd year
and go on increasing, then Lessee will structure the Lease Rent so as to pay more amounts in the 4thyear

and onwards.
Note: A variant of Balloon Lease Rentals, is the concept of Balloon Payment, i.e. Lease Rentals are generally low
throughout the lease, but a Balloon Payment is made at a future date. This is a lump sum payment which seeks to
cover the shortfall in the lease rentals collected each year. Subsequently, normal lease Rentals are charged.

7. Write short notes on Cross Border Leasing.

1. Meaning:
a. Cross – BorderLeasing (CBL) is a leasing arrangement where Lessor are situated in different countries.

b. CBL can be considered as an alternative to Equipment Loans to Foreign Buyers, wherein down payment,
payment streams, and lease – endoptions are the same as offered under Equipment Loans. However,
documentation procedures are different in Leases and Loans. [Note: In CBL, Operating Leases may be

feasible for exports of large equipment with a long economic life relative to the lease term.]
2. Number of Countries involved:
a. Two Countries: Generally, in a Cross – BorderLease or International Lease, Lessor and Lessee are situated in
two different countries. [Note: The Lease may also be routed through a third nation known as “Convenient

Country” for tax or equipment registration purposes.]

b. Three Countries: When the Manufacturer / Vendor, Lessor and Lessee are situated in three different
countries, this type of CBL is called Foreign to Foreign Lease.
c. Four Countries: Sometimes, in addition to Manufacturer, Lessor, and Lessee, a fourth nation may be

involved for Debt in a particular currency required to give effect to the Equipment Purchase and Lease
Transaction.
Effect: More nations involved in CBL would mean more complications in terms of different legal, fiscal, credit and
currency requirements and risk involved.
3. Advantages / Objectives:
a. Credit Availability: Funding for long period and at fixed rate which may not be available in the Lessee’s
home market may be obtained internationally, through CBL.
b. Asset 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.
c. Tax Savings, i.e. Double – DipLease: CBL is widely used toarbitrage the difference in the tax laws of different
countries, thus leading to tax avoidance and tax shelters. This is possible since each country applies different
rules for determining "Owner" for depreciation benefits, tax benefits, etc. thus, with sufficiently long leases

(often 99 years), an asset can end up with two effective owners, one each in different countries.
 CMA. CHANDER DUREJA [9811981369] LORD KRISHNA COMMERCE ACADEMY 7.6

d. Sale and Lease Back: If the Original Owner of an asset is not subject to taxation in any country, and hence
not able to claim depreciation, CBL involves selling such asset to an Investor (in another country, who can
claim depreciation), and long – termleasing it right back to the Owner.

e. Infrastructure: In developing countries, CBL is used as a meansof financing infrastructure development – Rail,
Air Transport Equipment, Telephone and Telecommunications, Equipment, and assets incorporated into
PowerGeneration and Distribution Systems, and other projects that have predictable revenue streams.
f. Lower Cost: CBL reduces the overall cost of financing, particularly if Tax Savings on Depreciation available to

the Lessor, are passed through to the Lessee as a lower cost of finance. For this purpose, the basic pre –
requisites are –
i. Relatively high tax rates in the Lessor's country,
ii. Liberal depreciation rules, and

iii. Either very flexible or formalistic rules governing tax ownership.

g. Security: The Lessor is often able to utilize Non – RecourseDebt to finance a substantial portion of the
equipment cost. The Debt is secured by, among other things, a mortgage on the equipment and by an

assignment of the right to receive payments under the lease.

h. Accounting Treatment: Also, depending on the structure, in some countries the Lessor can utilize very
favourable "Leveraged Lease" Financial Accounting treatment for the overall transaction.
i. 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 securedleander.
j. Defeasing and Currency Management: Appropriate Currency Requirements can be met easily to match
the specific Cash Flow needs of the Lessee.
8. Explain the concept of Break Even Lease Rental (BELR) from Lessee's

Lessee’s Perspetive Lessor’s Perspective

 BELR is the maximum Lease Rental the Lessee  BELR is the minimum (floor) Lease Rental, which
would be willing to pay. If BELR < Actual Rent Lessor should accept. If BELR < Actual Rent, the
Payable, the lease option would not be viable lease proposal should not be accepted by the
from Lessee's viewpoint. Lessor.
 At BELR level, the Net Advantage of Leasing  At BELR, the Net Advantage of Leasing (NAL)
(NAL) will be zero. from Lessor’s viewpoint will be zero.
 BELR is the rental at which the Lessee is
indifferent between Borrowing and Buying
Option and Lease Financing Option.