UNIT:3

Lease:
A written agreement under which a property owner (lessor) allows a tenant (lessee) to use the
property for a specified period of time and rent. The lessor owns the asset and for a fee allows the
lessee to use the asset. At the end of the period of contract (lease period) the asset /equipment
reverts back to the lessor unless there is a provision for the renewal of the contract.
It is a devise of financing the cost of an asset. It is a contract in which a specific equipment
required by the lessee is purchased by the lessor (financier) from a manufacturer /vendor selected
by the lessee. The real function of a lessor is not renting of the asset but lending of funds /
finance/ credit . In effect lease financing is in effect a contract of lending money.
Modes of terminating a lease:
1. The lease is renewed on a perpetual basis or for a definite period.
2. The asset reverts to the lessor.
3. The asset reverts to the lessor and the lessor sells it to a third party or to the lessee.
Risk with reference to leasing refers to the possibility of loss arising on account of
underutilization or technological obsolescence of the equipment.
Reward means the incremental net cash flows that are generated from the usage of the equipment
over its life and the realization of the anticipated residual value on expiry.
Operating Leases
Usually not fully amortized.
The lessor does not transfers all the risk and rewards incidental to the ownership of the asset to
the lessee.
The cost of asset is not fully amortized during the primary lease period
Usually require the lessor to maintain and insure the asset.
The leaser provides services attached to the leased asset such as maintenance, repair and
technical advice.
Lessee enjoys a cancellation option.
Examples: computers, office equipments, automobiles, telephone etc.,
Financial Leases or Full Pay Out leases
The exact opposite of an operating lease.
1. Do not provide for maintenance or service by the lessor.
2. The lessor transfers all the risk and rewards incidental to the ownership of the asset to the
lessee, whether or not the title is eventually transferred.
3. Financial leases are fully amortized.
4. The lessee usually has a right to renew the lease at expiry.
5. Generally, financial leases cannot be cancelled.
6. Example: Ships, aircrafts, railway wagons, lands, building, heavy machinery, diesel generator
sets etc.,
Sale and LeaseBack
A particular type of financial lease.
Occurs when a company sells an asset it already owns to another firm and immediately leases it
from them.
Example: sale and lease back of safe deposit vaults by banks. Banks sell the vaults in their
custody to a leasing company at market price substantially higher than the book value and the
leasing company in turn offers these lockers on a long term basis to the bank.

 The banks sublease these lockers to its customers.

The lease back arrangement in sale and lease back of leasing can be in the form of a finance
lease or an operating lease.
Two sets of cash flows occur:
The lessee receives cash today from the sale.
The lessee agrees to make periodic lease payments, thereby retaining the use of the asset.
Direct lease:
The owner of the equipment are two different entities.
This can be of two types:
a. Bipartite
b. Tripartite.
Leveraged Leases
A leveraged lease is another type of financial lease.
A threesided arrangement g between the lessee, the lessor, and lenders.
The lessor owns the asset and for a fee allows the lessee to use the asset.
The lessor borrows to partially finance the asset.
The lenders typically use a nonrecourse loan. This means that the lessor is not obligated to the
lender in case of a default by the lessee.
Significances and Limitations or Reasons for Leasing
Advantages to the lessee
Financing of capital goods.
Additional source of finance.
Less costly
Avoids conditionality. on other types loans representations in board, conversion of debt into
equity, payment of dividend etc.,
Flexibility in structuring the rentals.
Simplicity.
Tax benefits.
Obsolescence risk is averted.
Advantages to the lessor
Full security.
Tax benefit.
Significances and Limitations or Reasons for Leasing
Advantages to the lessor
Full security.
Tax benefit.
High profitability.
Trading on equity leaser may have lesser equity and use a substantial amount of borrowing
tax benefits.
High growth potential.
Significances and Limitations or Reasons for Leasing
Limitations of leasing:
Restrictions on use of equipment.
Limitations of financial leasing.
Loss of residual value.
Consequences of default.
Understatement of lessees asset since the leased asset does not form part of the lessees there
is an effective understatement of his assets, which may sometimes lead to gross underestimation
of the lessee.

 Double sales tax sales tax may be charged twice

Hire purchase
With a hire purchase agreement, after all the payments have been made, the business customer
becomes the owner of the equipment.
This ownership transfer either automatically or on payment of an option to purchase fee.
For tax purposes, from the beginning of the agreement the business customer is treated as the
owner of the equipment and so can claim capital allowances.
Capital allowances can be a significant tax incentive for businesses to invest in new plant and
machinery or to upgrade information systems.
Under a hire purchase agreement, the business customer is normally responsible for
maintenance of the equipment.
Hire Purchase vs Lease Financing
Ownership of the Asset:
In lease, ownership lies with the lessor.
The lessee has the right to use the equipment and does not have an option to purchase.
Whereas in hire purchase, the hirer has the option to purchase.
The hirer becomes the owner of the asset/equipment immediately after the last
installment is paid.
Depreciation:
In lease financing, the depreciation is claimed as an expense in the books of
lessor.
On the other hand, the depreciation claim is allowed to the hirer in case of hire
purchase transaction.
Rental Payments:
The lease rentals cover the cost of using an asset.
Normally, it is derived with the cost of an asset over the asset life.
In case of hire purchase, installment is inclusive of the principal amount and the
interest for the time period the asset is utilized.
Duration:
Generally lease agreements are done for longer duration and for bigger assets like land, property
etc.
Hire Purchase agreements are done mostly for shorter duration and cheaper assets like hiring a
car, machinery etc.
Tax Impact:
In lease agreement, the total lease rentals are shown as expenditure by the lessee.
In hire purchase, the hirer claims the depreciation of asset as an expense
Repairs and Maintenance:
Repairs and maintenance of the asset in financial lease is the responsibility of the lessee but in
operating lease, it is the responsibility of the lessor. In hire purchase, the responsibility lies with
the hirer.
Extent of Finance: Lease financing can be called the complete financing option in which no
down payments are required but in case of hire purchase, the normally 20 to 25 % margin money
is required to be paid upfront by the hirer. Therefore, we call it a partial finance like loans etc.
Lease vs Buy Decision
Lease vs. Buy Overview
When you lease a car, you dont own it. Instead, you pay for what you use - the difference
between the value of the car when you take possession and its value when you return it. When
you buy, you pay the full purchase price and you own the thing.
Restrictions
As you make the lease vs. buy decision you should carefully consider any restrictions that come

with a lease. When leasing, you may have: Maximum annual mileage limits Inability to get out of
a lease and switch cars Inability to modify or upgrade the car Requirements to keep the cars
interior, exterior, and working parts 'like new'
Lease vs. Buy Costs
In general, youll have lower short term costs if you lease vs. buy. You can get a nicer vehicle
with a smaller monthly payment. However, the long term costs are higher. In part, this is because
you never own anything. By buying the vehicle you end up with something you can sell allowing
you to recoup some of your costs - or use until it dies.
Lease vs Buy Decision
You may also have higher costs than you expected if you lease vs. buy the vehicle. If you exceed
your mileage limit or have to repair cosmetic damage (that you could just live with if you owned
the car) your costs will rise.
Negotiation
Some people avoid the lease vs. buy decision altogether because they think you can only
negotiate when you buy. In fact, the purchase price is negotiable even when you lease. Likewise,
you can shop for different lease agreements among a variety of vendors; youre not limited to the
auto dealers offerings.

Lease vs Buy Decision

Arguments for Leasing
Here are some factors that would make you decide to lease vs. buy your
vehicle:
You need a nice, new automobile (for client travel, for example)
You know that you can satisfy the lease agreement
You take care of your vehicles
You do not drive more than 15,000 miles per year
Arguments for Getting a Loan
Here are some factors that would tilt the lease vs. buy decision towards buying:
You are most concerned with minimizing long term costs
You drive more than 15,000 miles per year
You like to drive your car into the ground before replacing it
You want the flexibility to change or sell your car at any time
Hire Purchase and Instalment Decision

Expansion
Merger and Acquisition
Asset acquisition
Joint ventures
Tender offer

Types of Takeovers
General Guidelines

Takeover
The transfer of control from one ownership group to another.
Acquisition
The purchase of one firm by another
Merger
The combination of two firms into a new legal entity
A new company is created
Both sets of shareholders have to approve the transaction.
Amalgamation
A genuine merger in which both sets of shareholders must approve the transaction
Requires a fairness opinion by an independent expert on the true value of the firms shares
when a public minority exists
Friendly Acquisition
The acquisition of a target company that is willing to be taken over. Usually, the target will
accommodate overtures and provide access to confidential information to facilitate the scoping
and due diligence processes.
ADVANTAGES
REDUCTION OF COMPETITION
PUTTING AN END TO PRICE CUTTING
ECONOMIES OF SCALE IN PRODUCTION
RESEACH AND DEVELOPMENT
MARKETING AND MANAGEMENT
Friendly Takeovers
Structuring the Acquisition
In friendly takeovers, both parties have the opportunity to structure the deal to their mutual
satisfaction including:
1. Taxation Issues cash for share purchases trigger capital gains so share exchanges may be a
viable alternative
2. Asset purchases rather share purchases that may:
Give the target firm cash to retire debt and restructure financing
Acquiring firm will have a new asset base to maximize CCA deductions
Permit escape from some contingent liabilities (usually excluding claims resulting from
environmental lawsuits and control orders that cannot severed from the assets involved)
3. Earn outs where there is an agreement for an initial purchase price with conditional later
payments depending on the performance of the target after acquisition.
Hostile Takeovers
A takeover in which the target has no desire to be acquired and actively rebuffs the acquirer and
refuses to provide any confidential information.
The acquirer usually has already accumulated an interest in the target (20% of the outstanding
shares) and this preemptive investment indicates the strength of resolve of the acquirer.
Hostile Takeovers
The Typical Process
The typical hostile takeover process:
1. Slowly acquire a toehold ( beach head) by y q ) y open market purchase of shares at market
prices without attracting attention.
2. File statement with OSC at the 10% early warning stage while not trying to attract too much
attention.
3. Accumulate 20% of the outstanding shares through open market purchase over a longer period
of time
4. Make a tender offer to bring ownership percentage to the desired level (either the control
(50.1%) or amalgamation level (67%)) this offer contains a provision that it will be made only if
a certain minimum percentage is obtained.

During this process the acquirer will try to monitor management/board reaction and fight attempts
by them to put into effect shareholder rights plans or to launch other defensive tactics.
Classifications Mergers and Acquisitions
1. Horizontal
A merger in which two firms in the same industry combine.
Often in an attempt to achieve economies of scale and/or scope.
2. Vertical
A merger in which one firm acquires a supplier or another firm that is closer to its existing
customers.
Often in an attempt to control supply or distribution channels.
3. Conglomerate
A merger in which two firms in unrelated businesses combine.
Purpose is often to diversify the company by combining uncorrelated assets and income
streams
4. Crossborder (International) M&As
A merger or acquisition involving a Canadian and a foreign firm a either the acquiring or target
company.
CONGLOMERATE MERGER
UNRELATED INDUSTRIES MERGE PURPOSE
DIVERSIFICATION OF RISK
Ex:Time warner(they were into media & movie production) & AOL(leading American
website)
Contraction
1.Spin offshares in subsidiary distributed to its own shareholders
Kotak Mahendra Capital finance Ltd formed a subsidiary called Kotak Mahendra Capital
Corporation by spinning off its investment division.
2.Split off A new company is created to takeover an existing division or unit.
It does not result in any cash inflow to the parent company
VERTICAL MERGER
FIRMS SUPPLYING RAW MATERIALS MERGE WITH FIRM THAT SELLS ADVANTAGE
LOWER BUYING COST OF MATERIAL
LOWER DISTRIBUITION COST
ASSURED SUPPLIES AND MARKET
COST ADVANTAGE
Mergers and Acquisition Activity
M&A activity seems to come in waves through the economic cycle domestically, or
in response to globalization issues such as:
Formation and development of trading zones or blocks (EU, North America Free Trade
Agreement
Deregulation
Sector booms such as energy or metals
Table on the following slide depicts major M&A waves since the late 1800s.
Motivations for Mergers and Acquisitions
Creation of Synergy Motive for M&As The primary motive should be the creation of synergy.
Synergy value is created from economies of integrating a target and acquiring a company;
the amount by which the value of the combined firm exceeds the sum value of the two individual
firms. Creation of Synergy Motive for M&As

Synergy is the additional value created (V) :

V V -(V V ) A T A T D = + [ 15-1] Where:
VT = the premerger value of the target firm
VA T= value of the post merger firm
VA = value of the premerger acquiring firm
Value Creation Motivations for
M&As
Operating Synergies
1. Economies of Scale
Reducing capacity (consolidation in the number of firms in the industry)
Spreading fixed costs (increase size of firm so fixed costs per unit are decreased)
Geographic synergies (consolidation in regional disparate operations to operate on a national or
international basis)
2. Economies of Scope
Combination of two activities reduces costs
3. Complementary Strengths
Combining the different relative strengths of the two firms creates a firm with both strengths
that are complementary to one another.
Value Creation Motivations for
M&A
Efficiency Increases and Financing Synergies Efficiency Increases
New management team will be more efficient and add more value than what the target now
has.
The combined firm can make use of unused production/sales/marketing channel capacity
Financing Synergy
Reduced cash flow variability
Increase in debt capacity
Reduction in average issuing costs
Value Creation Motivations for M&A
Tax Benefits and Strategic Realignments
Tax Benefits
Make better use of tax deductions and credits
Use them before they lapse or expire (loss carryback, carryforward provisions)
Use of deduction in a higher tax bracket to obtain a large tax shield
Use of deductions to offset taxable income (nonoperating capital losses offsetting taxable
capital gains that the target firm was unable to use)
New firm will have operating income to make full use of available CCA. Strategic
Realignments
Permits new strategies that were not feasible for prior to the acquisition because of the
acquisition of new management skills, connections to markets or people, and new
products/services.
Managerial Motivations for M&As
Managers may have their own motivations to pursue M&As. The two most common, are not
necessarily in the best interest of the firm or shareholders, but do address common needs of
managers
1. Increased firm size
Managers are often more highly rewarded financially for building a bigger business
(compensation tied to assets under administration for example)
Many associate power and prestige with the size of the firm.
2. Reduced firm risk through diversification

 Managers have an undiversified stake in the business (unlike shareholders

who hold a diversified portfolio of investments and dont need the firm to be diversified) and so
they tend to dislike risk (volatility of sales and profits)
M&As can be used to diversify the company and reduce volatility (risk) that might concern
managers.
Empirical Evidence of Gains
through M&As
Target shareholders gain the most
Through premiums g p paid to them to acquire their shares
15 20% for stockfinance acquisitions
25 30% for cashfinanced acquisitions (triggering capital gains taxes for these shareholders)
Gains may be greater for shareholders will to wait for arbs to negotiate higher offers or
bidding wars develop between multiple acquirers.
Valuation Issues in Corporate Takeovers
Mergers and Acquisitions
Valuation Issues
What is Fair Market Value?
Fair market value ( FMV) is the highest ) g price obtainable in an open and unrestricted market
between knowledgeable, informed and prudent parties acting at arms length, with neither party
being under any compulsion to transact.