2. Characteristics
Periodical payment of rentals
Lessor Lessee
Right to use an asset for
a fixed period of time
Ownership rests with the lessor
3. Term
Lease Period = Lease agreement is
operational
Perpetual lease
Primary
Lease Period
Secondary
4. Tests for Financial Lease
Substance Test: Lessee Compliance with No.2 point
Full Payment Test: Lessor Compliance with No.8 point
–
Transfer of Title Test: Lessee has an option to buy the
asset
Lease Term Test: Lease term extends to the asset’s
life
5. Myths about Leasing
Off-balance sheet financing
No evaluation for capital expenditure – Cash flow
consequences?
Better Performance – Possible to enhance ROI, but
the transaction should yield a positive
NPV
6. Advantages of Leasing
Advantages to the lessor:
1. Stable Business – Lessee’s continued patronage
2. Sale of spare parts
3. Second-hand market
4. Tax benefits
5. Fillip to capital market
6.Easy finance
7. Advantages of Leasing
Advantages to the Lessee:
1. Efficient use of funds - No capital investment
2. Cheaper Source - than buying option
3. Enhanced borrowing capacity - Lower D/E Ratio
4. Off-balance sheet borrowing - - do -
5. Tax benefits
6. Guard against obsolescence - Lessee can terminate the
lease at any time
and take up another
asset under fresh
lease
8. Limitations
Disguised form of debt financing
Loss of depreciation tax shield, when depreciation
rates are high and leasing is preferred over buying
Possibility of double sales tax in certain states
Unfavourable capital gearing for the lessee
No ownership
Default Risk
Working Capital not considered
Indiscriminate finance
9. Tax Aspects of Leasing
Lessor:
Deduction of depreciation from taxable income
Income from lease rentals is taxable under “Profits and Gains
of Business and Profession”
Deductible expenses:
Depreciation
Rent, rates, taxes, repairs and insurance
Amortization of preliminary expenses
Interest on borrowed capital
Bad debts
All expenses incurred in furtherance of business
Entertainment expenses (with a cap)
Travel expenses (as per approved norms)
(See Illustration No.3.5 M Y Khan)
10. Lessee:
Allowability of lease rentals – allowed as normal
business expenditure if they are not i. of capital nature, ii.
Personal expense and relates only to the business purpose.
Deductibility of Incidental Expenses – Repairs,
Maintenance, Insurance, Finance Charges,…(Incidental)
Installation expense (revenue expense in the year of
incurrence)
11. Tax Planning
Lessee:
Flexible Restructuring of Lease Rentals –
Substantial part of the lease rentals payable in the first year and
a very small fraction during the remaining lease term
Lower rentals in earlier years and higher in later years depending
on cash flows
Purely tax-driven structure of lease rentals not allowed by the IT
authorities
(See Illustration No.3.6 M Y Khan)
Transfer of Investment-related Unabsorbed Tax Shield –
Lessee firm enjoys 100% tax deduction (exports) – Tax shield on
fresh capital investment would not have any impact on its cash
flows – Tax shields can be transferred to the lessor who will
consider lower lease rentals
(See Illustration No.3.7 M Y Khan)
12. Funding Aspects of Leasing
Deposits – Major source of finance
Bank Borrowings –
Maximum Limit – 10 times of NOF including deposits,
borrowings from banks/FIs, debentures, bonds
Maximum bank borrowings would be 3 times of NOF where
75% of the company’s assets are in equipment leasing and
where 75% of its gross income is from leasing
NOF = Paid up Capital + Free Reserves – Accumulated
balance of loss, where Free Reserves represent share
premium account, capital and debenture redemption reserves
and any other reserve not created for payment of any future
liability or for depreciation in assets or for bad debts or a
reserve created by revaluation of assets
RBI has freed the restrictions w.e.f.April 1997
13. Nature of Facility – based on the expected flow of lease
rental receivables
Maximum Permissible Bank Finance –
Calculate outstanding credit for next five years
Calculate relevant Drawing Power against that particular
transaction
Exclude – a. Funds raised from financial/inv. Institutions
b. DPGs provided by banks, and c. Assets created against
DPGs issued by banks
This will imply bank finance will be to an extent of 2 – 3
times of NOF.
14. Requirements for Bank Finance
Current Ratio – Minimum 1.33
Reports - (See page no. 203 Dr S Gurusamy)
15. Lessee’s Perspective of Leasing
Lease rental payments are similar to payments of
interest on debt
Hence, alternative to borrowing
Choice between debt financing versus lease financing
Decision-criterion – Net Present Value of Leasing/Net
Advantage of Leasing – NPV(L)/NAL
Discount Rate used is the marginal cost of capital for
all cash flows except lease payments and tax cost of
debt for lease payments
Value of interest tax shield is included as a foregone
cash flow in the computation of NPV(L)/NAL
16. NPV(L)/NAL
NPV(L)/NAL = Investment Cost
- PV of lease payment (discounted by Kd)
- PV of tax shield on lease payment (discounted by
Kc)
- Management Fee
+ PV of tax shield on management fee (disc.by Kc)
- PV of Depreciation shield (discounted by Kc)
- PV of Interest Shield (discounted by Kc)
- PV of residual/salvage value (discounted by Kc)
Where Kc = Post-tax marginal cost of capital, and
Kd = Pre-tax cost of long-term debt
17. NPV(L)/NAL negative means leasing alternative
should be used.
NPV(L)/NAL positive means borrowing alternative
would be preferable.
Alternative approach is
Determine the PVs of cash outflows after taxes under both the
alternatives
Select the alternative with the lower PV of cash outflows
(See Illustration No.4.1 M Y Khan)
18. Break-Even Lease Rental (BELR)
for lessee
The point where the Net Advantage of Leasing (NAL)
is zero.
The rental at which the lessee is indifferent between
lease financing and borrowing/buying.
Maximum level of rental which the lessee is willing to
pay
If the BELR > the actual rental, the lease proposal
would be acceptable.
(See Illustration No. 4.4 M Y Khan)
19. Lessor’s Perspective of Leasing
Whether to accept a lease proposal, or to
choose from alternative proposals
Determine break-even rental for the lessor,
negotiation and fixation of lease rentals
(See Illustration No.4.5 M Y Khan)
• BELR for a lessor – minimum lease rental which he
can accept
• NAL/NPV(L) at this level of rental is zero.
• Discount Rate to compute NAL is the marginal over-all
cost of funds to the lessor
(See Illustration No. 4.6 M Y Khan)