Unit-3

Leasing
Effort only fully releases its reward
after a person refuses to quit.
- Napoleon Hill
The words you consistently
select will shape your destiny.
- Anthony Robbins
 Leasing
• Defined as a contract b/w the owner of assets (lessor)
and it’s user (lessee) under which the assets is bailed by
its owner for a specified period in return for a periodical
rental payments.
 Types of Lease
• 1. Financing Leasing
• Known as long term leasing, capital lease, full payment lease.
• Lease period is generally equal to the expected economic life of the machinery.
• Contractual period under financing leasing can be split into two parts –
• 1. primary lease period- pre determined period during this period the lease co.
generally recover almost complete cost of machinery and some amount of
profit.
• 2. secondary lease- during which lease rental subsequently used reduced.
• Financial leasing is not cancellable.
• Particulary all the risks incendentally to asset ownership and benefits arising
there from transfer to leesser.
• The leesse uses the machinery exclusively, maintains it, insures it, and avails
after sale service if any.
• 2. Operating Lease-
• Known short term , service or maintainance lease.
• The lease period generally lower than the full economic
life of the asset.
• Contact is cancellable with proper prior notice( with
some penalty).
• The Risks and rewards incidental to ownership are
retained with the lessor.
• The lessor does not recover its investment during the
initial period of leasing.
• Operating leases are suitable for equipments which are
highly sensitive to obsolescence.
• OL lease amount will be high.
 Fin Op lease

Time Long term contract (approximate the economic life of Short term (shorter than the economic life
Duration the asset) of the assets)

Risk and rewards incident to ownership are passed to Risk and reward incident to the lessor.
the lessee.

Its non cancellable. Its cancellable (but with prior notice)

Lessee bear the risk of obsolescence. Lessor bear the risk of obsolescence.

Provided by the lessee Provided by lessor

The lessor is interested in his rentals and not in the Lessor does not have difficulty in leasing
asset. He must get his principal back along with interest the same assets to willing party. (lease is
or profit. (bcz of non cancellable.) cancellable.)
• 3. Direct leasing-
• Leasing arrangement all manufactures or vendors provides asset on
lease to lessee.
• A firm (lessee) acquires the right to use an asset from the
manufacturer.
• Ownership remains with the manufacturer or vendor or lessor.
• 3. Sale and lease back-
• Under this , the owner of the asset sells to a party (buyer ) who in
turn leases back the same assets to the owner in consideration of
lease rentals.
• Sold at the approximate its market value (buying at low cost bcz of
negotiation).
• Most of the sale and lease arrangements are on a Net – Net basis
which means that lessee pays all the maintainaince expenses, taxes,
insurance , and lease payment.
• Most of the sale and lease back arrangements are allow the lesse to
repurchase the property at the termination of lease.
• Lessor (financial institutions, banks and independent leasing
companies ).
• Example – Indigo Sales and lease back
• 5. Leveraged leasing-
• Under this, a 3rd party is involved besides lessor and
lessee. The lessor borrows part of the purchase cost
(may be 70%, or 90%, 40% ) of the asset from the 3rd
party or lender .
• Purchased assets is the security or collateral against loan
or borrowing.
• As an owner of the assets , the lessor is entitled to
depreciation associated with the asset.
A positive attitude is a person’s
passport to a better tomorrow.
 Advantages
• Lessee-
of leasing
• 1. Proves flexibility to lessee or purchasing alternative of machinery.
• 2. Leasing allows business to upgrade assets more frequently they have
the latest equipment without having to make further capital outlays or
without incurring large amount of capital.
• 3. leasing enables lessee to preserve precious cash reserve.
• Lessor-
• 1. Lessor retains the ownership of the leased asset thus the fully interest
secured.
• 2. generates regular income (leasing amount includes both Cost and
Interest).
• 3. claim the depreciation on the leased asset. Able to reduce tax liability.
• 4. Lessor can transfer maintains expenses to the lessee (financing leasing,
sales and lease back or depend upon the agreement.)
Disadvantages of leasing
• 1. certain restrictions on the use of assets.
• 2. Its non cancellable in some cases or if cancellable
then lessee has to pay penalty.
• 3. From lessee- cant claim depreciation (in operating
lease)
 Leverage Lease
• Q1. Assume the Hypothetical Leasing Ltd (HLL) has structured a
leveraged lease with an investment cost of `50 crore. The
investment is to be financed by equity from it and loan from the
Hypothetical Bank Ltd (HBL) in the ratio of 1:4. The interest on loan
may be assumed to be 20 per cent per annum to be repaid in five
equated annual instalments. If the required rate of return (gross
yield) of the HLL is 24 per cent, calculate
• (i) the equated annual instalment and
• (ii) the annual lease rental.
Annual inst * PVFA = PV of cash flows
annual inst = pv of cash flow/ PVAF
Annual Lease Rental (X)
Annual cash flow to HLL = (X – 13.4 crore)
Given the required rate of return of HLL of 24 per cent
(X – 13.4 crore) * PVIFA (24, 5) = 10 crore
(X – 13.4 crore) * 2.745 = 10 crore
2.745 X – 36.783 crore = 10 crore
2.745 X = 46.783 crore
X = 17.04 crore

In terms of the standard quote, the lease rental works out to be Rs. 340/Rs. 1,000 per
annum i.e. (17.04 crore * 1000)
• Flexibility in Structuring of Rentals (advantage of leasing from Lessee
perspective) :-

The lease rentals can be structured to accommodate the cash flow

position of the lessee, making the payment of rentals convenient to
him. The lease rentals are so tailor-made that the lessee is able to pay
the rentals from the funds generated from operations. The lease period
is also chosen so as to suit the lessee’s capacity to pay rentals and
considering the operating life-span of the asset.
Q2.The following data relate to the Hypothetical Leasing Ltd:
(1) Investment outlay/cost, `100 lakh
(2) Pre-tax required rate of return, 20 per cent per annum
(3) Primary lease period, 5 years
(4) Residual value (after primary period), Nil
(5) Assumptions regarding alternative rental structures:
(A) Equated/Level,
(B) Stepped (15 per cent increase per annum),
(C) Ballooned (annual rental of `10 lakh for years, 1-4),
(D) Deferred (deferment period of 2 years)
Y* PVIF (20,1) + (1.15)Y * PVIF (20,2) + (1.15)2 Y * PVIF (20,3) + (1.15)3 Y * PVIF
(20,4) + (1.15)4Y * PVIF (20,5) = 100 lakh
Y [0.833 + (1.15* 0.694) + (1.152* 0.579) + (1.153* 0.482) + (1.154* 0.402)]= 100
3.833 Y = 100 lakh

Y = 26.10 lakh, where Y denotes the annual rental in year 1.

The lease rentals in different years over the lease term will be:
Year 2 = 26.10 * 1.15 = 30.02 lakh
Year 3 = 30.02 * 1.15 = 34.52 lakh
Year 4 = 34.52 * 1.15= 39.70 lakh
Year 5 = 39.70 * 1.15 = 45.65 lakh
Let Y denotes the ballooned payment in year 5

10* PVIFA (20,4) + Y*PVIF (20,5) = 100 lakh

10* 2.59 + Y* 0.402 = 100 lakh

0.402 Y = 100 lakh – 25.9 lakh
Y = (74.10 lakh/ 0.402) = 184.33 lakh
Y denotes ballooned payment in 5 year.
Denoting Y as the equated annual rental to be charged between years 3-5

Y * PVIF (20,3) + Y * PVIF (20,4) + Y * PVIF (20,5) = `100 lakh

Y [0.579 + 0.482 + 0.402] = 100

1.463 Y = 100 lakh

Y = `68.35 lakh
Financial Evaluation of Leasing (Lessee’s
Perspective)
• The decision-criterion used is the Net Present Value of Leasing
[NPV(L)]/Net Advantage of Leasing (NAL).
• NPV(L)/NAL = Investment cost
• Less: Present value of lease payment (discounted by Kd),
• Plus: Present value of tax shield on lease payment (discounted by Kc)
• Less: Management fee
• Plus: Present value of tax shield on management fee (discounted by Kc)
• Minus: Present value of depreciation shield (discounted by Kc)
• Minus: Present value of interest shield (discounted by Kc)
• Minus: Present value of residual/salvage value (discounted by Kc)
where Kc = Post-tax marginal cost of capital
Kd = Pre-tax cost of long-term debt
# If the NAL/NPV(L) is positive, the leasing alternative should be used, otherwise the
borrowing alternative would be preferable.
For the purpose of financial evaluation, the two methods in vogue are:
(1) Present-value method and
(2) Internal-rate of return method.
1. Present-value method-
1st Step- Determine the cash outflows after taxes for each year under
the lease alternative. This is arrived at multiplying the lease rental
payment (L) by (1 – tax rate, t).
2nd Step- Determine the cash outflows after taxes for each year under
the buy/borrow alternative. The COAT is equal to the loan instalment
(Gross cash outflows, GCO)
Less (i) tax advantage on interest (I) component of loan instalment (I *
t) and
(ii) tax shield due to depreciation allowance (D*t).
3rd Step- Compare the PV of the cash outflows associated with leasing
(Step 1) and buy/borrow alternative (Step 2) by employing after-tax
cost of debt (kd) as the discount rate.
Select the alternative with the lower PV of cash outflow after taxes.
Decision criterion is:
(a) In favour of buy/borrow alternative if PV of COAT under lease
alternative > PV of COAT under buy/borrow alternative.
(b) In favour of lease alternative in case PV of COAT under lease
alternative < PV of COAT under buy/borrow alternative
Q3. XYZ Ltd is in the business of manufacturing steel utensils. The firm is planning to diversify
and add a new product line. The firm either can buy the required machinery or get it on lease.

The machine can be purchased for `15,00,000. It is expected to have a useful life of 5 years
with salvage value of `1,00,000 after the expiry of 5 years. The purchase can be financed by
20 per cent loan repayable in 5 equal annual instalments (inclusive of interest) becoming due
at the end of each year. Alternatively, the machine can be taken on year-end lease rentals of
`4,50,000 for 5 years. Advise the company, which option it should choose.

For your exercise, you may assume the following:

(i) The machine will constitute a separate block for depreciation purposes. The company
follows written down value method of depreciation, the rate of depreciation being 25 per cent.
(ii) Tax rate is 35 per cent and cost of capital is 18 per cent.
(iii) Lease rents are to be paid at the end of the year.
(iv) Maintenance expenses estimated at `30,000 per year are to be borne by the lessee.