LEASING

Parvesh Aghi
BASICS
Arrangement between two parties, the leasing
company or lessor and the user or lessee.
The lessor buys the capital equipment for the use
of the lessee for an agreed period of time in
return for the payment of the rent.
The rentals are pre-determined and payable at
fixed interval of time.
Lessor remains the owner of equipment
2
Types of Lease

1. Financial Lease
2. Operating Lease
3. Leverage Lease
4. Sale and Lease back
5. Cross Border Lease
3
Advantages of Lease

Permit alternative use of funds
Faster and cheaper credit
Flexibility
Facilitate additional borrowing
Protection against obsolescence
Hundred percent financing
Boon to small firm
4
Financial Lease

Irrevocable and non-cancelable
contractual agreement.
Lessee uses the asset exclusively for a relatively
longer period, maintains it, insures and avails of
the after sales service and warranty backing it.
Lessee bears the risk of obsolescence as it
stands committed to pay for entire lease period.
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Financial lease with the purchase option, where
at the end of pre-determined period, the lessee
has the option to buy the equipment / asset at a
pre-determined value.
The leasing company / lessor charges nominal
service charges to lessee towards legal and other
costs.
6
Operating Lease
Contractual period between lessor and lessee is
less than full economic life of equipment i.e.
short-term in nature.
The lease is terminable by giving stipulated
notice as per the agreement.
The risk of obsolescence is enforced on the
lessor who will also bear the cost of maintenance
and other relevant expenses
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Sale and Lease Back
Arrangement where a firm which has an asset
sells it to leasing company / lessor and gets it
back on lease.
Lessee gets the sale price in the market value
and gets the right to use the asset during the
lease period. Title of the asset remains with the
lessor.
Lease back agreements are on net basis i.e.
lessee pays the maintenance, property tax and
insurance premium.
8
Cross Border Lease
It is international leasing and is referred otherwise
as transactional leasing.
Relates to lease transaction between different a
lessor and lessee domiciled in different countries.
Illustration:- Leasing company in USA makes
available Air Bus on lease to Air India.
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Disadvantages of Leasing

Lease rentals are payable soon after entering into
lease agreement while in new projects cash
generation may start after gestation period.
The cost of financing is higher than debt
financing.
If the lessee defaults in payment, lessor would
suffer a loss.
10
Legal Aspects of Leasing
Under Section 148 of Indian Contract Act leasing
is executed.
The lessor has the duty to deliver the asset to
lessee, legally authorizes lessee to use the asset.
The lessee has the obligation to pay the lease
rentals as per lease agreement, to protect
lessors title, to take reasonable care of the
asset, and to return the leased asset on the
expiry of lease period.
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Income Tax Provisions Relating to Leasing
The lessee can claim lease rentals as tax -
deductible expenses.
The lease rentals received by lessor are taxable
under the head of Profits and Gains of Business
or Profession
The lessor can claim investment allowance and
depreciation on the investment made in leased
assets
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Accounting Treatment of Lease
The leased asset is shown on the balance sheet
of the lessor.
Depreciation and other tax shields associated
with leased asset are claimed by the lessor.
The entire lease rental is treated as an income in
the books of the lessor and expense in the books
of lessee
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Problems of Leasing
Unhealthy Competition
Lack of qualified personnel
Tax Considerations
Stamp Duty
Delayed Payments and Bad Debts
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XYZ Co is planning to install a machine which
becomes scrap in 3 years . Scrap realizes 18 lakhs It
requires an investment of Rs 180 lakhs the company
has following options
1) to take a loan @18% and buy that machine . The
loan is repayable in 3 equal year end installment
2) take it on lease @ 444/1000 payable annually for 3
years
Depreciation is 40% , tax rate is 35% .which option is
better
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CA FINAL
Welsh Ltd is faced with a decision to purchase or
acquire on lease a mini car. The cost of mini car
is Rs 126965 . It has a life of 5 years .
The mini car can be obtained on lease by paying
equal lease rentals annually the leasing company
desires a return of 10% on the gross value of the
asset .
Welsh ltd can also obtain 100% finance from its
regular banking channel. The rate of interest will
be 15% p.a and the loan will be paid in 5 equal
installments , inclusive of interest .
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The effective rate of tax rate of the company is
40%. For the purpose of taxation it is to be
assumed that the asset will be written off over a
period of 5 years on straight line basis
A) advise Welsh limited about the method of
acquiring the car
B) what should be the annual lease rental to be
charged by the leasing company to match the
loan option
Assume leasing and borrowing installments are payable in advance

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BUY OPTION
Equated Annual Loan installment = loan amount/ PVIFA ( 15% ,5)

= Rs 126965/ 3.86 = Rs 32892
Year 0 1 2 3 4
Opening Bal 126965 94073 75292 53694 28856
Interest
15%
14111 11294 8054 4036
Total 108184 86586 61748 32892
Repayment 32892 32892 32892 32892 32892
Closing Bal 94073 75292 53694 28856 0
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BUY OPTION
Depreciation by SLM = 129965/5= 25393
Discounting rate for analysis 15% (1-.4)= 9%
Year Installm
ent
Interest
15%
Depreci
ation
Tax
shield
on int +
Depr
Net
Cash
Flow
PV @
9%
PV of
cash
out
flows
0 32892 - 32892 1.00 32892
1 32892 14111 25393 15802 17090 .92 15723
2 32892 11294 25393 14675 18217 .84 15302
3 32892 8054 25393 13379 19513 .77 15025
4 32892 4036 25393 11772 21120 .71 14995
5 0 25393 10157 (10157) .65 (6602)
Total Present Value of Cash Outflows 87335
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Lease Option
Annual lease Rentals = Cost of the car / ( 1+ PVIFA ( 10% ,5)
= 126965/ 4.17= Rs 30 447
Year Lease
payment
Tax shield After tax
cash flows
PV factors
at 9%
PV of Cssh
flows
0 30447 0 30447 1 30447
1-4 30447 12179 18268 3.24 59188
5 0 12179 (12179) .65 (7916)
Total present value of cash out flows 81719
Decision : since PV of leasing is lower than that of buying , it is advisable to go for
leasing
B. let the annual rental be L
After tax cost of lease rental = L x ( 1-t) = .60L
PV of lease Rentals = .60L x 4.17= 2.502L
Equating 2.502L = Rs 87335 , we get L as 34906
Therefore break even lease rentals matching the loan option = 34906



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CA FINAL NOV 2011
Your company is considering acquiring an additional
computer to supplement its time share services to clients .
It has two options
A ) to purchase the computer for Rs 22 lakhs
B ) to lease the computer for 3 years from a leasing
company for Rs 5 lakhs as annual lease rent + 10% of
gross time share service revenue .
The agreement also requires an additional payment of Rs
6 lakhs at the end of third year .
Lease rents are payable at year end and the computer
reverts to lessor after the contract period
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The company estimates that the computer under review
will be worth Rs 10 lakhs at the end of third year forecast
revenues are :

Annual operating costs excluding depreciation / lease rent
of the computer are estimated at Rs 9 lakhs with an
additional Rs 1lakh for start up and training costs at the
beginning of the first year. These costs are borne by the
lessee. Your company will borrow at 16% interest to
finance the acquisition of the computer . Repayment is to
be made according to the following schedule :
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Year 1 2 3
Amount ( rs Lakhs) 22.5 25 27.5
Year End 1 2 3
Principal 500 850 850
Interest 352 272 136
The company uses the straight line method of depreciation to depreciate
its assets and pays 50% tax on its income . The management approaches
the CA for advice . Which alternative would be recommended and Why ?
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Depreciation = ( 22,00,000- 10,00,000)/3
= Rs 4,00,000 p.a.
Applicable discount rate for leasing & buying
after tax cost of debt = 16 ( 1-.5) = 8%
Operating and training costs are not considered ,
as they are incurred under both the options
Same logic applied for not taking into account the
revenues
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Leasing Costs
Years
1 2 3
Lease Rent 5,00,000 5,00,000 5,00,000
10% - Gross
revenue
2,25,000 2,50,000 2,75,000
Lump sum
payment
6,00,000
Total 7,25,000 7,50,000 13,75,000
Tax shield 50% 3,62,500 3,75,000 6,87,500
Net cash Out flow 3,62,500 3,75,000 6,87,500
PV factor .926 .857 .794
PV of cash out
flows
3,35,675 3,21,375 5,45,875
Total PV Cash out flows = Rs 12,02,925
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Cost of borrowing
YEARS
1 2 3
Principal 5,00,000 8,50,000 8,50,000
Interest 3,52,000 2,72,000 1,36,000
Tax shield on
interest 50%
1,76,000 1,36,000 68,000
Tax shield on
Depreciation
2,00,000 2,00,000 2,00,000
Salvage Value (10,00,000)
Net 4,76,000 7,86,000 (2,82,000)
PV factor .926 .857 .794
PV of cash out
flow
4,40,776 6,73,602 (223908)
Total PV of Cash out flow = Rs 8,90,470. Since the PV of net outflow of
borrowing is less , it is suggested to purchase the computer instead of
leasing it.
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CA FINAL MAY 2010
P ltd has decided to acquire a machine costing Rs 50 Lakhs through
leasing . Quotations from 2 leasing companies have been obtained
which are summarized below.
Pltd evaluates investment proposals at 10 % cost of capital and its
effective rate of tax is 30% . Terminal payment in both the cases is
negligible and may be ignored
Make calculations to show which quote is beneficial to p ltd .
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Quote A Quote B
Lease term 3 years 4 years
Initial lease rent Rs Lakhs 5 1
Annual Lease rent ( payable in arrears ) Rs lakhs 21.06 19.66
Period 0 1 2 3 4
term 1 .91 .83 .75 .68
Quote
A
3 years 5 21.06 21.06 21.06 0 40.34
Quote
B
4 years 1 19.66 19.66 19.66 19.66 44.35
Quote A = 5 + 21.06(1-.3)x (.91+.83+.75)-..3x .91x 5= 40.34 lakhs
Quote B = 1.00+ 19.66 (1-.3) ( .91+.83+.75) - .3 x .91x 1= 44.35 lakhs
Owing to different terms , we find the equivalent values

Therefore , for quote A : 40.34/ PVIFA ( 10, 3) = 16.23
For Quote B : 44.35 / PVIFA ( 10,4) = 14
Since equivalent value of quote B is lower , the same is beneficial than
quote A
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