LEASE EVALUATION:

LEASE:
A lease is a contract conferring a right on one person (called a tenant or lessee) to
possess property belonging to another person (called a landlord or lessor) to the
exclusion of the owner landlord. It is a rental agreement between landlord and tenant.[1]
The relationship between the tenant and the landlord is called a tenancy, and the right
to possession by the tenant is sometimes called a leasehold interest. A lease can be for
a fixed period of time (called the term of the lease) but may be terminated sooner. The
consideration of the lease is called rent or rental.

LEASE EVALUATION: THE LESSE’S ANGLE:

A Finance lease can be evaluated either as an investment alternative or as a financing
alternative depending upon the a priori information available about the financial
desirability of a capital investment. In the absence of any a priori information about the
financial desirability, ‘Leasing’, and ‘Buying’ are evaluated as two mutually exclusive
investment alternatives. Given prior knowledge of the financial desirability or need for a
capital investment, ‘Leasing ‘is evaluated as one of the financial alternatives.

FINANCIAL MODELS FOR EVALUATION OF THE LEASE:

There are a number of financial models for evaluating a lease and there is no
consensus till date on the most appropriate model. The following four
financial models represent the spectrum of views on this issue reasonably
well:

A Weingartner Model

B Equivalent Loan Model

C Bower- Her ringer- Williamson model

D Bower Model

Barring the first model, the other three models are evaluating the leasing as
a financial alternative.

– The application of the Weingartner Model to evaluate a lease as an

investment alternative involves the following steps:
 A) Compute the NPVs of the lease and buy alternatives
B) Select the alternative with the higher positive NPV.
-The application of the Weingartner Model for evaluating a lease as a
financing alternative involves the following steps:

A) Compute the NET ADVANTAGES OF LEASING (NAL) defined as:

NAL = Initial investment – P.V (Lease Rentals) – Management Fee + P.V. (Tax
Shield on Lease rentals) + P.V. (Tax Shield on Management Fee) – P.V. (Tax
Shield on Depreciation) – P.V.(Net Salvage Value).

B Lease the equipment if NAL is positive. Buy the equipment if NAL is

negative.

The discount rate employed is the marginal cost of capital based on the mix
of the debt and equity in the target capital structure. The model assumes
that debt includes present and future lease obligations as well.

– The Equivalent Loan Model, The BHW model And the Bower Model view
‘Leasing’ as a financing alternative and is based on the premise that every
rupee of lease finance displaces an equal amount of long term debt. In other
words, these models assume that the debt component in the target capital
structure does not include present and future lease obligations. So, these
models consider the interest tax shield on the displaced debt as an explicit
cash flow in the computation of NAL. .The models differ from one another in
terms of the discount rates applied to the components of NAL viz., lease
payments, tax shields (shelters) and net salvage value. The following table
provides the different discount rates employed by these models:
 Components of Equivalent loan BHW model Bower model
NAL Model
A Lease Pre- Tax Cost of Pre-Tax Cost of Pre- tax cost of
payments debt debt debt
B Tax Shield Post tax cost of Marginal cost of To be specified
debt capital by the decision
maker
C Net Salvage -Do- - Do- Marginal cost of
Value capital
–
– We believe that the risk characterizes the lease payment on the one hand
and the realization of the tax shelters and the net salvage valve on the other
hand are different. Hence different discount rates have to be used to
discount the two set of tax flows. For reasons stated we also believe that
debt displacement effect of leasing must be explicitly recognized and now
NAL is:

NAL= Investment cost- P.V (lease payments discounted at Kd) + P.V (Tax
shield on lease payments discounted at K)- Management Fees +P.V ( Tax
shield on management fees discounted at K)- P.V ( Depreciation Tax shield
discounted at K) – P.V ( Residential value discounted at K)

Kd= Pre-Tax cost of Debt

K= Marginal cost of capital

Setting NAL to 0 and solving the unknown rental value provides the break
even rental from the lessee’s point of view- the maximum lease rental
acceptable to lessee.

LEASE EVALUATION: THE LESSOR’S ANGLE:

The Net Advantage of Leasing from Lessor’s point of view can be defined as
follows:
 NAL= - Initial investment + P.V (Lease payments) – P.V ( Tax on lease
payments) + P.V (Management fee) –P.V ( Tax on management fee) + P.V
( Tax shield on Depreciation ) + P.V ( Net Salvage Value) – P.V ( Indirect
cost) = P.V ( Tax shield on initial direct cost).

– The bargaining area or the range within which the rentals can be negotiated
between the lessor and the lessee is determined by the break even rental of
the lessor and the lessee. The upper limit is determined by the break even
rental of the lessee and the lower limit is set by the break even rental of the
lessor. Clearly, no negotiable range exists if the break even rental of the
lessor exceeds that of the lessee.
– Lessor who use the gross yield approach to price the lease define the gross
yield as that rate of interest which equates the present value of the lease
rentals plus the present value of the residential value of the investment cost.
– The flat rate of interest applicable to a lease is called the add on yield. The
assumption underlying the computation of add on yield is that the
investment in the lease remains constant over the lease period, which is
untrue. The add on yield is always less than the (effective) gross yield
defined above.
– The Internal rate of return (IRR) on a lease is that rate of interest for which
NAL is equal to zero. The lease proposal is accepted if and only if IRR is
greater than the marginal cost of capital.
– The total risk of the lease portfolio can be divided in to following types of the
risk:

A Default Risk

B Residual Value Risk

C Interest rate risk

D Purchasing Power Risk

E Political risk

F Currency and the cross border risk.

– The relevant and the dominant risk characterizing a finance lease is the
default risk. The default risk is the function of the creditworthiness of the
lessee which is influenced by the character and capacity of the lessee and
the collateral value of the asset.
– The overall credit rating of the lessee based on the relevant factors can be
determined through the explicit judge mental approach and the statistical
approach. These approaches primarily help in discriminating between the
good and the bad lessee account and also help in developing a risk
classification table.
– The credit risk can be managed by altering one or more of the lease
structuring variables like leases rentals, lease term or pattern of the
payments. The Lessor can also seek protection against credit risk by
insisting on personal and bank guarantee.
– The relevant risk in the case of an operating lease is the product risk or the
risk inherent in realizing the expected salvage value. In the countries like
USA and UK, insurance companies offer the residual value of the insurance
policies to cover such risks.