Lease Finance

Lease Finance
Lease is contract between the owner of the asset
(Lessor) and the user (Lessee) of the asset, wherein the
Lessor 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.
Leasing

Leasing, Hire Purchase, Instalment Sale

Leasing:
Lessor retains the Ownership of the asset & claims the
benefit 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 1st instalment
is paid. The balance amount is treated as a secured loan
and Interest portion is Tax-deductible
Leasing

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

Leasing

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.
Leasing

Operating Lease
Short-term Lease: Lease period is less than the
economic life of the asset.
Asset leased is not fully amortised: Lease rentals
required to be paid under a lease agreement are not
sufficient to recover fully the investment in the leased
asset.
Lease is cancellable at short notice without substantial
penalty,
Lessor is responsible for the insurance & maintenance
of the asset.
Lessor bears the risk of obsolescence.
E.g.: Taking a Taxi for travelling from one place to
another
Lessor retains most of the risks associated with the
ownership of the asset in case of Operating Lease.
Leasing

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.
Equipment Manufacturer
(Lessor)

Leases
Equipment to

User Firm
(Lessee)

Leasing Company purchases the asset, as per the specification of

the firm and then lease it out to the firm.
Equipment
Manufacturer
(Seller)
Leasing

Sells
Equipment to

Leasing
Firm
(Lessor)

Leases
Equipment to

User Firm
(Lessee)
7

Other Types of Lease (Contd.)

Sale & Lease Back The firm sells the asset to a leasing company
and then leases the same asset back to the firm.
Leasing
Company
(New Owner/Lessor)

Sells
Equipment to

Takes Back the

Equipment on Lease

User Firm
(Old Owner/Lessee)

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

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 of
a 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 with
ownership of the asset.
From Lessees point of view, there is no difference between
Leveraged Lease & Non- Leveraged lease.
Leasing

Other Types of Lease (Contd.)

Big Ticket Lease : where the relative magnitude of investment
involved is high e.g.. Leasing of Aircrafts.
Dry Lease: Operating Lease where the Lessee bears the cost of
insurance, maintenance, repairs. e.g.: Dry lease of Aircrafts by AI
from SIA.
Wet Lease: Usual operating Lease i.e. Lessor bears the cost of
insurance and maintenance repair.

Lease Line: A lease life is similar to a bank line of credit where the
Lessee is allowed to add on to the leased asset under the same
basic terms without negotiating a fresh lease every time a new
equipment is leased. e.g.: Leasing of Bottles for beverages.
Upgrade Lease: Such Lease provides for automatic exchanges of
out-dated equipment with the latest version.
Sales-Aid Lease: Equipment manufacturer leases instead of sale.
Leasing

10

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/- of
funds borrowed.
If the asset cost is Rs. 40 Lacs, then the monthly lease rentals
would be :

40,00,000
25 = Rs.1,00,000/1000

Primary Lease period and Secondary Lease period

Besides, Lease rentals, upfront Lease management fees (say 1%

of funds) is also charged.
Leasing

11

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 taken
on HP is Rs. 30 Lacs, then the Hire Purchase instalments would
be:
Total interest on Rs 30 Lacs @ 12% for 3 years = Rs.10,80,000

Hire Purchase instalments:

Leasing

Annual:

30,00,000 + 10,80,000
=Rs.13,60,000.00
3

Monthly

30,00,000 + 10,80,000
=Rs.1,13,333.33
36

12

Hire Purchase - Quote

Splitting of instalments into Interest & Principal repayment is
based on Sum-of-years-digits (SYD) method.
Yr Proportion

Interest

Installment

Principal
Repayment

(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

(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

(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

10,80,000.00

40,80,000.00

30,00,000.00

Total
Leasing

13

Hire Purchase - Effective Interest rate

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

Case 1: Instalments paid in arrears:

Month
Loan
Instalments
Total CFs

34

35

36

-800
+30.89 +30.89 +30.89

+30.89 +30.89 +30.89

-800 +30.89 +30.89 +30.89

+30.89 +30.89 +30.89

IRR of Cash Flows: 0.01901 or 1.901%

Effective Interest rate (on Annual basis) = (1+0.1901)12 - 1 = 25.35%
Leasing

14

Hire Purchase - Effective Interest rate

Case 2: Instalments paid in advance:
Month
Loan

Instalments
Total CFs

34

36

-800

+30.89 +30.89 +30.89 +30.89

+30.89 +30.89

-769.11 +30.89 +30.89 +30.89

+30.89 +30.89

IRR of Cash Flows: 0.02025 or 2.025%

Effective Interest rate (on Annual basis) = (1+0.02025)12 - 1

Leasing

35

= 27.21%

15

Hire Purchase - Effective Interest rate

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
Case 3: Deposit with Instalments paid in arrears:
Month
Loan

+38.61

+38.61

+38.61

34

35

36

+38.61

+38.61

+38.61

-1000

Instalments
Deposit

+200

Total CFs

-800

-312.79
+38.61

+38.61

+38.61

+38.61

+38.61

-274.18

IRR of Cash Flows: 0.02304 or 2.304%

Effective Interest rate (on Annual basis) = (1+0.02304)12 1 = 31.47%
Leasing

16

Hire Purchase - Effective Interest rate

Case 4: Deposit with Instalments paid in advance:
Month
Loan

Instalments
Deposit
Total CFs

+38.61

+38.61

+38.61

34

35

+38.61

+38.61

36

-1000

+38.61
+200
-761.39

-312.79
+38.61

+38.61

+38.61

+38.61

+38.61

-312.79

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

Leasing

Instalments in Arrears

Instalments in Advance

Down payment

25.35%

27.21%

Deposit

31.47%

35.14%
17

Lease Evaluation

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 companys post-tax cost of capital is 10%. Assume the tax rate
as 35%.
Evaluate the lease proposal.

Lease

19

Lessees view point

Lease

20

Lessees view point

Lease

21

Lease

22

If NAL > 0, then Lease, provided NPV(P) is also > 0.

Lease

23

Lessees view point

Lease

24

Lessors view point

Lease

25

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 companys D/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 Limiteds point of view.

Lease

27

Lessees view point

Leasing

28

Lease Evaluation Lessees view point

Leasing

29

Lessees view point

Leasing

30

Lease Evaluation Lessees view point

Leasing

31

Lease Evaluation Lessees view point

(1+rq)4=1.16

Leasing

32

Lease Evaluation Lessees view point

1
1
PVIFA AD = (1+r)
n
r r(1+r)
1
1

(1.037802)=14.3826
20
0.037802
0.037802(1.037802)

Leasing

0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19

PVIFA @
3.7802%
1.0000
0.9636
0.9285
0.8947
0.8621
0.8307
0.8004
0.7713
0.7432
0.7161
0.6900
0.6649
0.6407
0.6173
0.5948
0.5732
0.5523
0.5322
0.5128
0.4941
14.3826

33

Lease Evaluation Lessors view point

Leasing

34

Lease Evaluation Lessors view point

Leasing

35

Lease Evaluation Lessors view point

Leasing

36

Lease Evaluation Lessors view point

0

PVIFA @
2.21%
1.0000

1
2
3

0.9784
0.9572
0.9365

4
5
6
7

0.9162
0.8964
0.8770
0.8580

8
9
10
11

0.8395
0.8213
0.8035
0.7862

12
13
14

0.7692
0.7525
0.7362

15
16
17
18

0.7203
0.7047
0.6895
0.6746

19

0.6600

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%

Leasing

PVIFA

16.3772

37

Lease Evaluation Lessees View

n

X t (1-T)+Dt T
Sn
NPV(P)=-A+
+
t
n
(1+k)
(1+k)
t=1
n

X t (1-T)+L t T n
Lt
NPV(L)=
-
t
t
(1+k*)
t=1
t=1 (1+k*)
n

X t (1-T)-L t (1-T)
=
t
(1+k*)
t=1

(assume k = k*)

NPV(L)-NPV(P)=NAL
Leasing

38

Lease Evaluation Lessees View (Contd.)

Case 1: Lease Rentals paid Yearly in arrears
n X (1-T)+D T
Sn
n X t (1-T)+L t T n L t
t
t
NAL=
-
- -A+
+
t
t
t
n
(1+k)
(1+k)
(1+k)
(1+k)
t=1
t=1
t=1

n X (1-T) n
X t (1-T) n L t T n L t
Dt T
Sn
t
=
+
+A-
t
t
t
t
t
(1+k)n
t=1 (1+k)
t=1 (1+k) t=1 (1+k)
t=1 (1+k)
t=1 (1+k)
n

L t (1-T) n Dt T
Sn
NAL=A-
t
t
n
(1+k)
t=1 (1+k)
t=1 (1+k)
n

Asset
Cost

Leasing

PV of Post Tax Lease

Rentals

PV of Depreciation Tax
Shield

PV of Salvage
Value
39

Lease vs. Hire Purchase

Lease vs. Hire Purchase

Lease:
Lease Rentals

Outflow

Tax Shield on Lease Rentals

Inflow

Or Post tax Lease Rentals

Outflow

Hire Purchase:

Lease

Interest portion of HP Instalments

Outflow

Tax Shield on Interest portion

Inflow

Or Post tax Interest portion of HP

instalments

Outflow

Principal Repayment

Outflow

Depreciation Tax Shield

Inflow

Salvage Value

Inflow
46

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?

Lease

47

Lease vs. Hire Purchase

Lease

48

Lease vs. Hire Purchase

Interest * SYD%

Lease

49

Lease vs. Hire Purchase

Lease

50

Lease vs. Hire Purchase

As the cost of Lease option is higher than Hire purchase option,

taking the equipment on Hire purchase is preferable.
Lease

51

Lease vs. Buy

Lease Evaluation Lessees view point

SaiTel Solutions Limited has shortlisted a new computer system
which shall cost Rs. 300 Lacs to buy. The asset shall depreciate on
SLM basis over its useful life of 3 years. The company has been
approached by a leasing company to provide the equipment on an
3 year lease with lease rentals of Rs. 110 Lacs per year (end of the
year). The tax rate for the company is 30% and its WACC is 15%.
Should the company take the equipment on lease?

Lease

53

Lease Evaluation Lessees view point

Lease

54