·4 Chapter

Objectives
After completing this chapter, you will be able to understand:
• Types of Lease. '
• Lease and Hire Purchase.
• Lease and Taxation.
• Accounting for lease.
Structure:
4.1 Introduction
4.2 Concept of Leasing
4.3 Step Involved in Leasing Transaction
4.4 Types of Lease
4.5 Operating Lease
4.6 Leverage Lease
4.7 Sale and Lease Back
4.8 Cross Border Lease
4.9 Installment Buying, Hire Purchase and Leasing
4.10 History and Development of Leasing
4.11 Legal Aspects of Leasing
4.12 Contents of a Lease Agreement
4.13 Income Tax Provisions Relating to Leasing
4.14 Sales Tax Provisions Pertaining to Leasing
4.15 Accounting Treatment of-Lease
4.16 Structure of Leasing Industry
4.17 Public Sector Leasing
4.18 Problems of Leasing
4.19 Prospects
4.20 Summary
4.21 Self Assessment Questions
4.1 INTRODUCTION
Traditionally firms acquire productive assets and use them as owners. The sources of finance to a
firm for finance to a firm for procuring assets may be internal or external. Over the years there
has been a declining trend in the internally generated resources of Indian companies due to low
profitability. the financial institutions experience paucity of funds at their disposal to meet the
increasing needs of borrowers. Further, modern business environment is becoming more and
more complex. To succeed in the situation, the firms aim at growth with stability. To accomplish
this objective, firms are required to go for massive expansion, diversification and modernization.
Essentially such projects involve a huge amount of investment. High rate of inflation, severe cost
escalation, heavy taxation and meager internal resources forced many companies to
look for alternative means of financing the projects. Leasing has emerged as a new
source of financing capital assets.
4.2 CONCEPT OF LEASING
Leasing, as a financing concept, is an arrangement between two parties, the
leasing company or lessor and the user or lessee, whereby the former arranges to buy
capital equipment for the use of the latter for an agreed period of time in return for the
payment of rent. The rentals are predetermined and payable at fixed intervals of time,
according to the mutual convenience of both the parties. However, the lessor remains
the owner of the equipment over the primary period.
By resorting to leasing, the lessee company is able to exploit the economic value
of the equipment by using it as if he owned it without having to pay for its capital cost.
Lease rentals can be conveniently paid over the lease period out of profits earned
from the use of the equipment and the rent is cent percent tax deductible.
A Lease is Defined as follows:
- Dictionary of Business and Management -
'Lease is a form of contract transferring the use or occupancy of land, space,
structure or equipment, in consideration of a payment, usually in the form of a rent.'
- James C. Van Horne -
'Lease is a contract whereby the owner of an asset (lessor) grants to another
party (lessee) the exclusive right to use the asset usually for an agreed period of time
in return for the payment of rent.'
- Equipment Leasing Association of UK -
'A Contract between lessor and lessee for the hire of a specific asset selected
from a manufacturer or vendor of such assets by the lessee. The lessor retains the
ownership of the asset. The lessee has possession and use of the asset on payment
of specified retain over the period.'
Thus in a contract of lease there are two parties involved (i) lessor and the lessee.
The lessor can be a company, a co-operative society, a partnership firm or an individual
in manufacturing or allied activities. The lessee can be even a doctor or any other
specialists who use costly equipment for the practice of his profession.
Leasing as a Source of Finance
Leasing is an important source of finance for the lessee. Leasing companies
finance for:
1. Modernisation of business.
2. Balancing equipment.
3. Cars, scooters and other vehicles and durables.
4. Items entitled to 100% or 50% depreciation.
5. Assets which are not being financed by banks/institutions.
4.3 STEP INVOLVED IN LEASING TRANSACTION
The steps involved in a leasing transaction are summarised as follows:
1. First, the lessee has to decide the asset required and select the supplier. He
has to decide about the design specifications, the price, warranties, terms of delivery,
servicing etc.
2. The lessee, then enters into a lease agreement with the lessor. The lease
agreement contains the terms and conditions of the lease such as,
(a) The basic lease period during which the lease is irrecoverable.
(b) The timing and amount of periodical rental payments during the lease
period.
(c) Details of any option to renew the lease or to purchase the asset at the
end of the period.
(d) Details regarding payment of cost of maintenance and repairs, taxes,
insurance and other expenses.
3. After the lease agreement is signed the lessor contacts the manufacturer and
requests him to supply the asset to the lessee. The lessor makes payment to the
manufacturer after the asset has been delivered and accepted by the lessee.
4.4 TYPES OF LEASE
The lease agreement can be classified broadly into four categories:
1. Financial Lease
A financial lease is also known as Capital lease, Long-term lease, Net lease and
Close lease. In a financial lease, the lessee selects the equipments, settles the rice
and terms of sale and arranges with a leasing company to buy it. He enters into a
irrevocable and non-cancellable contractual agreement with the leasing company.
The lessee uses the equipment exclusively, maintains it, insures and avails of the after
sales service and warranty backing it. He also bears the risk of obsolescence as it
stands committed to pay the rental for the entire lease period.
The financial lease could also be with purchase option, where at theend of the
predetermined period, the lessee has the option to buy the equipment at a predetermined
value or at a nominal value or at fair market price. The financial lease may also contain
a non cancellable clause which means that the lessor transfers the title to the lessee
at ·the end of the lease period.
Under a financial lease, the rate of lease would be fixed based on the kind of
lease, the period of lease, periodicity of rent payment, and the rate of depreciation and
other tax benefits available. The leasing company also charges nominal service
charges to cover legal and other costs. The leasing company may also insist on
collaterals or bank's guarantee in individual cases. In a large number of cases, the
financial leases are used as financing cum tax planning tool.
The .financial lease is very popular in India as in other countries like USA, UK and
Japan. On an all India basis, at present, approximately a lease worth Rs. 75 to Rs. 100
crores is transacted as a tax planning device. The high cost of equipments such as
office equipment, diesel generators, machine tools, textile machinery, containers,
locomotives etc., are leased under financial lease.
4.5 OPERATING LEASE
An operating lease is also known as Service lease, Short term lease or True
lease. In this lease, the contractual period between lessor and lessee is less than the
full expected economic life of equipment. This means that the lease is for a limited
period, may be a month, six months, a year or few years. The lease is terminable by
giving stipulated notice as per the agreement. Normally, the lease rentals will be
higher as compared to other leases on account of short period of primary lease. The
risk of obsolescence is enforced on the lessor who will also bear the cost of maintenance
and other relevant expenditure. The lessor also does the services like handling warranty
claims, paying taxes, scheduling and performing maintenance and keeping complete
records lease is suitable for,
(i) Computers, copy machines and other office equipments, vehicles, material
handling equipments etc. Which are sensitive to obsolescence and
(ii) Where the lessee is interested in tiding over temporary problem.
Distinction between a Financial Lease and Operating Lease
Financial Lease Operating Lease
1. A financial lease is like an installment
loan. It is a legal commitment to pay
for the entire cost of the equipment plus
interest over a specified period of time ..
The lessee commits to a series of
payment which in total exceed the cost
of the equipment.
2. It excludes provisions for maintenance
or taxes which are paid separately by
the lessee.
3. The risk of obsolescence is assumed
by the lessee
4. Contract period ranges from medium to
long term.
5. Contracts are usually non cancellable.
6. Air crafts, land and building heavy
machinery are leased.
7. The lease involves a financial
commitment similar to a loan by a
leasing company. It places the lessee
in a position of borrow,
8. The lessor fulfills financial function.
1. An operating lease is a rental agreement.
The lessee is not committed to paying
more than the original cost of equipment
during contractual period.
2.0perating lease provides for maintenance
expenses and taxes of the lessor.
3. Leasing company assumes risk of
obsolescence.
4. Contract period ranges from intermediate
to short-term.
5. Contracts are usually cancellable either
by the lessor or by the lessee.
6. Computers, office equipments,
automobiles, truck etc. are leased.
7. The financial commitment is restricted
to regular rental payment. The rentals
find a place in the P & LAic of the
lessee.
8. The lessor fulfills service function.
4.6 LEVERAGE LEASE
A leverage lease is used for financing those assets which require huge capital
outlay. The outlay for purchase cost of the asset generally varies from Rs. 50 lakhs
to Rs. 2 crore arid has economic life of 10 years or more. The leverage lease agreement
involves three parties, the lessee, the lessor and the lender. The lessor acquires the
assets as per the terms of the lease agreement but finances only a part of the total
. investment, say 20% to 50%. The balance is provided by a person or a group of
persons in the form of loan to the lessor. The loan is generally secured by mortgage
of the asset besides assignment of the leased rental payments -,The position of the
lessee under a leveraged leasing agreement is the same as in the case of any other
type of lease. In leveraged lease, a wide range of equipments such as rail road, rolling
stock, coal mining, electricity generating plants, pipe lines, ships etc. are acquired.
Under a leverage lease, there are some attractive investment features in the
form of after-tax consequences for the owner of the equipment. By investing 20.% or
25% of the cost of an asset, the lessor is entitled to 100% allowance for depreciation
plus the investment allowance. In addition, interest expenses related to his borrowings
are also tax deductible. From the point of view of lessee, lease rentals are deductible
in full as an operating expense.
4.7 SALE AND LEASE BACK
Under this type of lease, a firm which has an asset sells it to the leasing company
and gets it back on lease. The asset is generally sold at its market value. The firm
receives the sale price in cash and gets the right to use the asset during the lease
period. The firm makes periodical rental payment to the lessor. The title to the asset
vests with the lessor. Most of the lease back agreements are on a net - net basis
which means that the lessee pays all maintenance expenses, property taxes and
-insurance. In some cases, the lease agreement allows the lease to repurchase the
property at the termination of lease.
The sale and lease back agreement is beneficial to both lessor and lessee. The
lessor gets immediate cash which becomes available for working capital or for further
expansion and lessor gets tax benefits. Retail stores, office buildings, multipurpose
industrial building and shopping centres are financed under this method.
4.8 CROSS BORDER LEASE
Cross border lease is international leasing and is known as transnational leasing.
It relates to a lease transaction between a lessor and lessee domiciled in different
countries and includes exports leasing. In otherwords the lessor may be of one
country and the lessee may be of another country. To illustrate, if a leasing company
in USA makes a available an Air bus on lease to Air India, there would be a cross border
lease.
Indian leasing industry is unlikely to deal in export border leases for big ticket
items such as aircraft but it is well placed to contribute to India's export earnings by
offering the lease option. First Leasing Company has initiated discussions with Bulgar
Leasing of Bulgaria to export bull dozers and shovels in significant number of an
export lease to that country.
4.9 INSTALMENT BUYING, HIRE PURCHASE AND LEASING
In instalment buying, the property passes on to the buyer immediately as soon
as the first installment is made. The balance amount is payable in installments. Under
the contract of installment the buyer has no right to return the goods. In case of default,
the seller has the right to file a suit in the court of law to recover his dues.
Hire purchase is an agreement under which the owner delivers the goods to the
buyer who agrees to.make periodical payment as hire charges. The possession of
goods vests with the hirer but the ownership remains with the seller. On full payment
of hire charges, the buyer gets the option of purchasing the goods. On default, the
seller can reclaim the goods, subject to certain provisions of Hire Purchase Act.
Hire purchase resembles leasing in certain ways. In both the cases th~ right to.
use the equipment is transferred to .the hirer/lessee. .. . = ... ,
In leasing, the entire lease rentals represents a hire charge and it is treated as
expense and hence tax deductible. Under hire purchase, a part of installment represents
capital payment and hence it is not an expense. A part of the installment is interest on
the loan which is considered as revenue expenditure and hence it is tax deductible.
In leasing, rental charges are debited to profit and loss account and the leased
asset is not shown in the balance sheet of the lessee. As against this, the hire purchaser
capitalises the asset brought under hire purchaser contract. The liability for future hire
purchase installments not yet due is shown separately in the balance sheet.
Advantages of Lease
The following are the advantages of leasing:
1. Permit Alternative Use of Funds: A leasing arrangement provides a firm with
the use and control over asset without incurring huge capital expenditure. The firm is
required only to make periodical rental payments. It saves considerable funds for
alternative uses which would otherwise be tied up in fixed capital. •
2. Faster and Cheaper Credit: Depending on tax structure of the lessee it costs
less than other methods of acquiring assets. It permits firms to acquire new equipment
without going thorough formal scrutiny procedure. Hence acquisition of assets under
leasing agreement is cheaper and faster than any other source of finance.
3. Flexibility: Leasing arrangements may be tailored to the lessee's needs
more easily that ordinary financing. Lease rentals can be structured to match the
lessee's cash flows. It can be skipped during the months when the cash flows are
expected to below.
4. Facilitates Additional Borrowings: Leasing may increase long-term ability
to acquire funds. The lessee can utilise more funds for working capital needs. Moreover,
acquisition of assets under the lease agreement does not alter debt equity ratio.
Hence, the lessee can go for additional borrowings in case need arises.
5. Protection against obsolescence: A firm can avoid risk of obsolescence by
entering into operating lease agreement. This is highly useful in respect of assets
which become obsolete at a faster rate.
6. No Restrictive Covenants: The restrictive covenants such as debt equity
ratio, declaration of dividend etc., which are usually imposed under debenture or loan
agreement are absolutely absent in a lease agreement.
7. Hundred Percent Financing: Lease financing enables a firm to acquire the
use of an asset without having to make a down payment. So hundred percent financing
is assured to the lessee.
8. Boon to Small Firm: The firms which are either small or have uncertain
records of earning are able to obtain the use of asset through lease financing. It is a
boon to small firms and technocrats who are able to make promoter's contribution as
required by financial institutions.
Disadvantages of Leasing
1. Lease is not suitable mode of project finance. This is because rentals are
repayable soon after entering into lease agreement while in new projects cash generations
may start only after a long gestation period.
2. Certain tax benefits/incentives such as subsidy may not be available on leased
equipment.
3. The value of real assets such as land and building may increase during lease
period. In such a case the lessee loses the advantage of a potential capital gain.
4. The cost of financing is generally higher than that of debt financing.
5. A manufacturer who wants to discontinue a particular line of business will not
in a position to terminate the contract except by paying heavy penalties. If it is a owned
asset the manufacturer can sell the equipment at his will.
6. If the lessee is not able to pay rentals regularly, the lessor would suffer a loss
particularly when the asset is a sophisticated one and less liquid.
7. In case of lease agreement, it is lessor who has purchased the asset from the
supplier and notthe lessee. Hence, the lessee by himself is not entitled to any protection
in case the supplier commits breach of warranties in respect of the leased assets.
8. In the absence of exclusive laws dealing with the lease transaction, several
problems crop up between lessor and lessee resulting in unnecessary complications
and avoidable tension.
4.10 HISTORY AND DEVELOPMENT OF LEASING
The history of leasing dates back to 200 BC when Sumerians leased goods.
Romans had developed a full body law relating to lease for movable and immovable
property. However the modern concept of leasing appeared for the first time in 1877
when the Bell Telephone Company began renting telephones in the U.S.A. In 1832,
Cottrell and Leonard leased academic caps, gowns and hoods. Subsequently, during
1930s the Railway Industry used leasing service for its rolling stock needs. In the post
war period, the American Air Lines leased their jet engines for most of the new air
crafts. This development ignited immediate popularity for the lease and generated
growth of leasing industry.
Since World War II the use of leasing has been greatly expanded and is constantly
used for new products and new industries. In May 1952, Henry Scholfeld set up a
separate Corporation in the USA to handle lease transaction. He founded the US
Leasing Corporation with a capital of $20,000. Since 1963, commercial banks have
been allowed to engage themselves in direct leasing. In the early 1960s leasing
entered the United Kingdom following its successful and rapid development in the
USA.
The concept of financial leasing was pioneered in India during 1973. The First
Company was setup by the Chidambaram group in 1973 in Madras. The company
undertook leasing of industrial equipment as its main activity. The Twentieth centurv
Leasing Company Limited was established in 1979. By 1981, four finance companies
joined the fray. The performance of First Leasing Company Limited and the Twentieth
Century Leasing Company Limited motivated others to enter the leasing industry. In
1980's financial institutions made entry into leasing business. Industrial Credit and
Investment Corporation was the first all India financial institution to offer leasing in
1983. Entry of commercial banks into leasing was facilitated by an amendment of
Banking Regulation Act, 1949. State Bank of India was the first commercial bank to
set up a leasing subsidiary, SBI capital market, in October 1986. Can Bank Financial
Services Ltd., BOB Financial Service Ltd., and PNB Financial Services Limited followed
suit. Industrial Finance Corporation's Merchant Banking division started financing
leasing companies as well as equipment leasing and financial services. There was
thus virtual explosion in the number of leasing companies rising to about 400 companies
in 1990.
In the subsequent years, the adverse trends in capital market and other factors
led to a situation where apart from the institutional lessors, there were hardly 20 to 25
private leasing companies who were active in the field. The total volume of leasing
business transacted, by both private and public sector leasing companies was Rs.5000
crores in 1993 and it is expected to cross Rs. 10,000 crores by March 1995.
4.11 LEGAL ASPECTS OF LEASING
As there is no separate statute for equipment leasing in India, the provisions
relating to 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 the directions of the person delivering them. The person
delivering the goods is called the' bailor' and the person to whom they are delivered
is called the 'bailee".
Since an equipment lease transaction is regarded as a contract of bailment, the
obligations of the kessor and the lessee are similar to those of the bailor and the bailee
(other than those expressly specified in the least contract) as defined by the provisions
of sections 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 leased asset on the expiry of the lease period.
4.12 CONTENTS OF A LEASE AGREEMENT
The lease agreement specifies the legal rights and obligations of the lessor and
the lessee. It typically contains terms relating to the following:
1. Description of the lessor, the lessee, and the equipment.
2. Amount, time, and place of lease rental payments.
3. Time and place of equipment delivery.
4. Lessee's responsibility for taking delivery and possession of the leased
equipment. -
5. Lessee's responsibility for maintenance, repairs, registration, etc. and the
lessor's right in case of default by the lessee.
6. Lessee's right to enjoy the benefits of the warranties provided by the equipment
manufacturer/supplier.
7. Insurance to be taken by the lessee on behalf of the lessor.
8. Variation in lease rentals if there is a change in certain external factors like
bank interest rates, depreciation rates, and fiscal incentives.
9. Option of lease renewal for the lessee.
10. Return of equipment on expiry of the lease period.
11. Arbitration procedure in the event of dispute.
4.13 INCOME TAX PROVISIONS RELATING TO LEASING
The principal income-tax provisions relating to leasing are as follows:
1. The lessee can claim lease rentals as tax-deductible expenses.
2. The lease rentals received by the lessor are taxable under the head of 'Profits
and Gains of Business or Profession'.
3. The lessor can claim investment allowance (this may be doubtful) and
depreciation on the investment made in leased assets.
4.14 SALES TAX PROVISIONS PERTAINING TO LEASING
•
The major sales tax provisions relevant for leasinq are as follows:
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. (It may be noted that if a firm buys an asset for resale or for use
in manufacture it is entitled for the confessional rate of sales tax).
2. The 46th Amendment Act has brought lease transitions under the purview
of 'sale' and has empowered the central and state government to levy sales
tax on lease transactions. While the Central Sales Tax Act has yet to be
amended in this respect, several state governments have amended their
sales tax laws to impose sales tax on lease transactions.
4.15 ACCOUNTING TREATMENT OF LEASE
All particulars generally required as per legal requirements specified in Schedule
VI of the Companies Act.will also apply to leasing. The accounting treatment in the
books of the lesser will be as follows:
Books of Lessor
(i) The lesser has to disclose the asset given under lease agreement as an
asset in his balance sheet as per the method adopted for other fixed assets.
(ii) The lease rentals received under financial lease should be shown in the
income statement on the credit side under the head 'Gross Income'.
(iii) The lease rentals received should be shown on actual basis and not on
accrual basis.
(iv) A minimum statutory depreciation on leased asset should be charged to
income statement separately.
(v) Generally, a fair value of the leased asset to be recovered every year is
ascertained and it is called 'annual lease charge'.
(vi) When the annual lease charge is more than the statutory depreciation, the
difference is called Lease equalisation charge. It is also charged to Income
statement.
(vii) When the annual lease charge is less that the statutory depreciation, the
difference is again called lease equalisation charge. But, it is credited in the
income statement.
(viii) For adjusting the annual lease charge stated above a lease. Equalisation
Account and a Lease Adjustment Account will be opened as follows:
(a) When the Annual Lease Charge is more than the Minimum Statutory
Depreciation the Entry to be Passed is:
Lease Equalisation Account Dr.
To Lease Adjustment Alc
(b) When the Annual Lease Charge is less than the Minimum Statutory
Depreciation
Lease Adjustment Alc Dr.
To Lease Equalisation Account
Note: Balance in Lease Adjustment Alc will appear in the Balance Sheet whereas
the Lease Equalisation Alc will go to the Income Statement as shown below:
Dr. Profit and Loss Account Cr.
By Gross Income
xxxxx Lease rental
Add: Lease Equalisation
(or)
Less:Lease Equalisation
xxxxx
To Statutory
Depreciation
xxxxx
Balance Sheet
Assets
Fixed Assets
Leasehold Asset xxxxx
Less:Accumulated
Depreciation xxx
Less:Lease Adjustment xxx xxxxx
Books of Lessee
For the financial lease, no special treatment is necessary in the books of the
lessee since it is a off-balance sheet financing. Hence the following treatment is
necessary:
(i) The assets taken under lease agreement should be shown by way of a
footnote in the Balance Sheet.
(ii) However, the lease rentals paid should be charged to the Income Statement.
(iii) The lease rentals should be shown on accrual basis. Hence, necessary
adjustments should be made for any outstanding or prepaid lease rent in the
income statement as well as in the Balance Sheet.
(iv) It is also desirable to disclose the future obligations of the lease as per lease
agreement by way of a footnote.
Method of Ascertaining Lease Rentals
From the lessee's point of view, as seen already, he has to make an important
financial decision - whether to buy a capital equipment or take it on a lease basis.
Similarly, from the lessor's point of view, he has to be very careful in computing the
lease rentals so that he may not suffer due to any loss at a later stage. Generally, the
following method is adopted for determining the lease rentals:
Determination of Lease Rentals
The following steps may be adopted for determining the lease rentals:
1. First, findout the total cost of the asset.
Total cost = Cost of the asset + Freight charges + Insurance + Taxes +
Installation charges etc.
2. Then, ascertain the cash flows to the lessor on account of ownership of the
asset. While ascertaining the cash flows, the tax advantage on depreciation, investment
allowance, if any etc. should be taken into account. The cash flows should be computed
for each year separately as follows:
Cash flow = Amount of depreciation - Tax advantage on depreciation - Tax
advantage on Investment allowance + *Salvage value
*Note: It should be considered only in the last year of the life of the asset.
3. The new step is to calculate the present value of already computed cash flows
(as stated in Step 2) year-wise with the help of P.V. factor. Generally the present value
Factor at a certain percentage discount rate will be given. So, it is easy to calculate
the PV of cash flows as follows:
For example: PV factor @ 10% discount
I Year = 0.813, II Year = 0.717, III Year = 0.697, IV Year = 0.606, V Year = 0.517
PV of cash flows = Cash flow for each year x PV factor at a given discount rate
4. The fourth step is to ascertain the minimum required net recovery through
lease rentals with the help of the following formula.
Minimum required net recovery = Cost of the - The present value
through Lease Rental (MRLR) asset (Step 1) of cash flow (step 3)
5. From this MRLR, it is easy to find out the post-tax lease rentals with the help
of the present value factor of annuity. This annuity discount factor at the specified
discount rate for a specified period will also be given. For egoAnnuity Discount factor
at 10% Discount for 5 years = 3.105.
MRLR
Post-tax lease rental (PTLR) = PVfactor 0f Anrun'ty
6. Finally, the pre-tax lease rentals can be ascertained by adjusting the PTLR
for the tax factor as follows:
100
Pre-tax lease rental (LR) = PTLR x ----
Tax Rate
From this, lease rental for each month can be computed. Usually this rent will be
expressed in terms of per thousand and per month.
10000 1
Therefore the rate per month = Pre-tax lease rental (CR)x .. x-
Total cost of the asset 12
Buy or Lease Decision
Successful financial management requires taking sound financial decisions at
the appropriate time. One such decision is to decide whether to buy a capital asset
or to take it on a lease basis. These two alternate proposals should be carefully studied
before taking any final decision. The financial viability of both the proposals should be
evaluated by adopting the normal technique of capital budgeting. Generally, the NPV
(Net Present Value) technique is used for this purpose. The present values of net cash
outflows after tax from these two options should be compared and the one with lower
present value of cash outflows is to be selected.
Decision-making Process
For taking a final decision, the following factors should be taken into account:
(i) As usual calculate depreciation on the capital asset to be bought by applying
the formula:
D .. Cost of Asset - Salvage Value epreclation = --------=----
No. of Years of Life
(ii) Then, ascertain savings in tax on depreciation with the help of the tax rate.
Saving in tax on depreciation = Depreciation x Tax rate
(iii)Similarly, find out savings in.tax on interest paid with the help of the tax rate
for the given period.
(iv) Then, calculate the Present Value of After Tax cash outflows under purchase
option with the help of the appropriate discount rate (minimum required rate of return).
Generally, the present value of Re.1 due for the given period (any number of
years) can be found with the help of the following formula:
1
PV = (l + r)"
where, PV means present value
r refers to rate of interest/discount
n means number of years.
(v) For buy or lease decisions, the present value is found out by multiplying the
Net Cash outflow with the PV factor @ the discount rate.
(vi) Similarly, calculate the present value of After-tax cash outflows under lease
option.
(vii) Finally, see which proposal has the lower present value of cash outflows. For
example, after discounting all the after-tax cash outflows to the present value, over
the life of the asset say 10 years, we get
NPV of buying = x
PPV of leasing = y
If Y is lesser leasing option it has to be preferred and if x is lesser buying option
it has to be chosen.
Other Factors Influencing Buy/Borrow or Lease Decision
A firm may propose to acquire a certain asset either with equity funds or with a
financial lease. The firm's management in such a case, should take into consideration
certain factors while evaluating the above financial proposals. These factors are:
1. Capital Adequacy: If the firm has adequate shareholders' equity it is better
to go for buying the asset rather than taking it out on a lease basis. In the absence of
sufficient capital, raising new capital or retaining a greater proportion of earnings
should be considered rather than assuming further debt obligations through leasing.
2. Liquidity Considerations: A firm has to maintain sufficient liquidity for meeting
any sudden shortfall in cash inflows or for meeting any capital expenditures. If sufficient
liquidity is not available, leasing is the solution.
3. Flexibility Considerations: Buying an asset involves one time payment
which can not be flexible. If the asset is bought through borrowed funds, that will be
rigid repayment schedule. On the other hand leasing arrangements may be tailored
to the lessee's needs more easily and lease rentals can be structured to match the
lessee's cash flows. .
4. Nature of Asset: For those assets which become obsolete at a faster rate,
'buying' that asset is not preferable. The best solution is to go for operating leasing
which serves as a protection against obsolescence.
5. Availability of Finance: In the absence of adequate owned funds, one has
to go for borrowed funds to buy an asset. There is no guarantee for the continuous
availability of borrowed funds and there is a fear of repayment on demand stipulated
by some lending institutions. On the other hand fixed-rate finance may be available
by leasing the equipment and there is also a guaranteed continuous availability of
finance. Again, there may not be any restrictive covenants under leasing which are
normally found in all loan agreements.
6. Debt Capacity: From the lessee's point of view leasing is off-balance sheet
financing and hence it increases the overall debt capacity of a firm. Leasing plays a
vital role in a firm's overall financing strategy to the extent to which it enables the firm
to increase its overall debt raising capacity. Hence, buy or lease decision depends
upon the financing strategy of a firm also.
7. Grants and Incentives Consideration: Government grants, incentives and
other benefits are available for purchased equipment as well as leased equipment
depending upon the government's policy. Therefore, the method of finance either to
buy or lease should take into account the eligibility conditions to avail of such grants
and incentives.
8. Borrowing Restrictions: Borrowings for the purpose of acquiring an asset
may not be permitted due to some restrictive covenants and government regulations.
Sometimes the memorandum may restrict the borrowing powers of the company. In
such cases leasing is the only answer to acquire such assets.
9. Administrative Considerations: Buy or lease decision depends 'on
administrative conveniences like simplicity of book-keeping procedures, easy cash
flow forecasting etc. Generally firms prefer those methods of finance which facilitate
easy administration.
4.16 STRUCTURE OF LEASING INDUSTRY
The present structure of leasing industry in India consists of (i) Private Sector
Leasing and (ii) Public Sector Leasing.
The private sector leasing consists of:
(i) Pure Leasing Companies,
(ii) Hire Purchase and Finance Companies, and
(iii) Subsidiaries of Manufacturing Group Companies.
The public sector leasing organisations are divided into:
, (i) leasing divisions of financial institutions,
(ii) subsidiaries of public sector banks, and
(lli) other public sector leasing organisations.
(i) Pure Leasing Companies
These companies operate independently without any link or association with any
other organisation or group of organisation. The First Leasing Company of India
Limited. The Twentieth Century Finance Corporation Limited, and the Grover Leasing
Limited, fa" under this category.
(ii) Hire Purchase and Finance Companies
The companies started prior to 1980 to do hire purchase and finance business
especially for vehicles added leasing to their activities during 1980. Some of them do
leasing as major activity and some others do leasing on a small scale as a tax planning
device. Sundaram Finance Limited and Motor and General Finance Limited belong
to this group.
(iii) Subsidiaries of Manufacturing Group Companies
These companies consist of two categories,
(a) Vendor leasing .
(b) In house leasing
(a) Vendor Lea.sing: This type of companies are formed to boost and promote
the sale of its parent companies' products through offering leasing facilities.
(b) In House Leasing: In house leasing or capture leasing companies are set up
to meet the fund requirements or to avoid the income tax liabilities of the gr.oup
companies.
4.17 PUBLIC SECTOR LEASING
(i) Financial Institutions: The financial institution such as IFCI, ICICI, IRBI and
NSIC have set-up their leasing divisions or subsidiaries to do leasing business. The
shipping credit and Investment company of India offers leasing facilities in foreign
currencies for ships, deep seas fishing vehicles and related equipments to its clients.
(ii) Subsidiaries of Banks: The commercial banks in India can, under section
19(1) of the Banking Regulation Act, 1949, setup subsidiaries for undertaking leasing
activities. The SBI was the first bank to start a subsidiary for leasing business in 1986.
Leasing in SBI is transacted through, Strategic Business Unit (SBU) of the bank.
EachSBU is manned by specially trained staff and isequipped with the latest technological
aids to meet the needs of top corporate clients. For the bank as a whole, leasing is
considered as a high growth area. Now the bank is concentrating only on 'Big Ticket
Leasing' which is generally of Rs. 5 crore and above. So far SBI has disbursed more
than Rs. 300 crores by way of leasing with the average size of deal being Rs. 25 crores.
(iii) Other Public Sector Organisations: A few public sector manufacturing
companies such as Bharat Electronics Limited, Hinudustan Packaging Company
Limited, Electronic Corporation of India Limited have started to sell their equipment
through leasing.
4.18 PROBLEMS OF LEASING
Leasing has great potential in India. However, leasing in India faces serious
handicaps which may mar its growth in future. The following are some of the problems.
(i) Unhealthy Competition
The market for leasing has not grown with the same pace as the number of
lessors. As a result, there is over supply of lessors leading to competition. With the
leasing business becoming more competitive, the margin of profit for lessors has
dropped from four to five percent to the present 2.5 to 3 percent. Bank subsidiaries
and financial institutions have the competitive edge over the private sector concerns
because of cheap source of finance.
(ii) Lack of Qualified Personnel
Leasing requires qualified and experienced people at the helm of its affairs.
Leasing is a specialised business and persons constituting its top management should
have expertise in accounting, finance, legal and decision areas. In India, the concept
of leasing business is of recent one and hence it is difficult to get right man to deal with
leasing business. On account of this, operations of leasing business are bound to
suffer.
(iii) Tax Considerations
Most people believe that lessees prefer leasing because of the tax benefits if
offers. In reality, it only transfers, the benefit, i.e., the lessee's tax shelter is lessor's
burden. The lease becomes economically viable only when the transfer'S effective tax
rate is low. In addition, taxes like sales tax, wealth tax, additional tax, surcharge etc.
add to the cost of leasing. Thus leasing becomes more expensive from of financing
than conventional mode of finance such as hire purchase.
(iv) Stamp Duty
The States treat a leasing transaction as a sale for the purpose of making them
eligible to sales tax. On the contrary, for stamp duty, the transaction is treated as a
pure lease transaction. Accordingly a heavy stamp duty is lived on lease documents.
This adds to the burden of leasing industry.
(v) Delayed Payment and Bad Debts
The problem of delayed payment of rents and bad debts add to the costs of lease.
The lessor does not take into consideration this aspect while fixing the rentals at the
time of lease agreement. These problems would disturb prospects of leasing business.
4.19 PROSPECTS
Leasing today accounts for six percent of the total capital investment in India.
The 8th plan envisages capital formation of Rs. 8000 billion 50 per cent of which is to
take place in the private sector. Leasing will playa significant role to account for atleast
15 percent of gross capital formation.
The world leasing industry grew at a rate of about 10 per cent. As the economy
is opened up there will be substantial demand for a variety of leasing products such
as foreign currency leases, cross border leases, leverage leases etc. Leasing companies
set for substantial growth in line with international trends.
Leasing has great prospects in India. It is on the threshold of a major break
through in industrial development due to liberalised economic policy measures initiated
by the government. Leasing as a convenient and flexible financing option can playa
vital role in the process of industrial development. The leasing industry has taken the
centre stage with the government and public sector undertakings are looking to
industry to finance railway, telecommunication, transport, power and infrastructure
sectors. The infrastructure financing so crucial for an economic growth can not be
accelerated without leasing industry. The government has indicated that it is open to
suggestions for reviewing the existing policies. Such conduciveness and the willingness
to prevent bottlenecks in the area of taxation and other areas will go a long way in
speeding up the growth of the industry.
4.20 SUMMARY
Lease is a contract whereby the owner of an asset (lessor) grants to another
party (lessee) the exclusive right to use the asset usually for an agreed period of time
in return for payment of rent. Lease arrangement allows lessor to use equipment and
pay for it from profits earned from its use.
Leases are of four types; financial, operating, leverage and sale and lease back.
Advantages of lease are alternative use of funds available to lessee; faster and
cheaper credit, flexibility, protection against obsolescence etc.
However, lease arrangements are not suitable for project finance, may not have
tax incentives declared by the Government and normally cost more than debt financing.
There isrno separate Act to regulate leases and they are governed by the section
148 of the Contract Act on bailment. Lease rent paid by lessee is fully deductible for
tax purposes.
Lease is accounted by lessor showing the asset on his balance sheet and claiming
depreciation and other tax shields on the asset. The lease rent is treated as income
in lessor's books and as expense in lessee's books.
Both private and sectors provide lease finance.
The leasingbusinesssuffersfrom unhealthycompetition, lackof qualifiedpersonnel,
burden of sales tax as well as stamp duty, delays in payments including bad debts.
4.21 SELF ASSESSMENT QUESTIONS
'I. .r"
I. T.ru~or,False:
1. Infinancial lease, the contracts are cancellable either by the lessor or by the
lessee.
2. The average lease agreements involves three parties.
3. Vendor leasing companies are formed to promote the sale of its parent companies.
4. In house leasing companies are set up to avoid income tax liabilities of the group
companies.
5. The lessee can claim investment allowance.
[Key: 1.False, 2. True, 3. True, 4. True, 5. False]
II. Fill in the Blanks:
1. In financial lease, bears the risk of obsolescence.
2. lease is for a limited period.
3. The leased asset is shown on the Balance sheet of the _
4. An equipment lease transaction is regarded as a contract of _
5. The entire lease rental is treated as in the books of lessor.
[Key: 1. lessee, 2. operating lease, 3. lessor, 4. bailment, 5. income]
III. Short Answers:
1. What is cross border lease?
2. Write a note on 'Sale and Lease Back'
3. What is vendor leasing?
4. Define leasing.
5. What is leverage lease?
IV. Essay Type:
1. Discuss the advantages and disadvantages of leasing.
2. Explain the different kinds of leasing.
3. Explain the structure of leasing industry in India.
4. What are the problems of leasing in India.