Strategic Financial Management - Lease Financing

 

Strategic Financial Management

Lease Financing

 

Part A:

Discussion of basic theories of Lease Financing including

a) Definition of lease,

b) Types of leases,

c) Advantages of leasing transactions (both to the lessor and lessee),

d) How to make comparison between lease option and buy option,

e) What is Break-Even Lease Rental (both from the viewpoint of lessee and lessor), and

f) What is Leveraged Lease.

Part B:

11 Illustrations with Solutions.

Part A

Introduction

Organisations often require assets worth millions in order to produce goods or render services. Buying those assets outright may not always be a feasible option as it will essentially involve a large outflow of cash which can otherwise be invested in expansion projects. Again, debt financing may also not be cost effective. In such cases, financing the assets through leases may be an appropriate alternative. However, lease financing also comes with its own limitations and a final choice must be made only after a careful evaluation of a lease or buy options. Apart from the lessees, lessors also need to weigh a few important aspects while entering into a lease agreement. Calculating a break-even lease rental will guide him in evaluating a lease proposal.

 

A lease is basically an agreement between two parties, commonly known as lessor and lessee, whereby the lessor conveys to the lessee the right to use an asset for an agreed period of time in return for a payment or series of payments.

 

As mentioned above, a lease agreement has two parties associated with it – the lessor and the lessee. A lessor is the owner of the asset who conveys the right to use the asset to lessee. A lessee, on the other hand, is the person who makes either a lump-sum or periodic payments to continue to use the asset. The period for which such a right is conveyed by the lessor to the lessee is called the lease period.

 

In some cases, a lessee may again lease out entire or a part of the asset to another person. Such another person is termed as a sub-lessee. A sub-lease agreement is basically another lease agreement where original lessee assumes the role of a sub-lessor.

 

Types of Leases

Leases can broadly be classified into Finance Lease and Operating Lease. A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset. Thus, in such a lease, the lease period covers substantial life of the asset and hence the lease is found to be of long term in nature. Moreover, the payment towards lease rental covers substantial, if not all, the cost of obtaining the asset by the lessor, i.e. owner. On the other hand, an operating lease does not transfer substantially all the risks and rewards incidental to ownership of the asset.

 

Advantages of Leasing Transactions

Advantages to the Lessor

(a)        Full Security: Lessor’s interest is fully secured as he is always the owner of the asset and can take repossession of the asset, if the lessee defaults.

(b)        Tax Benefits: Tax relief is available to the lessor by way of depreciation. If the lessor is in high tax bracket, he can lease out assets with high depreciation rates and thus reduce his tax liability substantially. Generally, assets that are leased out carry a higher depreciation rate.

 

Advantages to the Lessee

(a)        Source of Financing: Leasing is a source of financing provided by the lessor to the lessee. The lessee may use the asset against payment of lease rental without purchasing the asset. Therefore, the amount which would have been required for purchasing the asset may be used for other purposes.

(b)        No Dilution of Ownership: Leasing provides finance without diluting the ownership or control of the promoters, unlike equity or debt financing.

 (c)        No Loss of Control: In case of Institutional Financing (from Bank and other Term Lending Institutions), the lender may have restrictive conditions in the sanction letter such as representation in the Board, conversion of debt into equity, payment of dividend, etc. Such restrictions are not present in case of lease financing. This enhances the independence of the firm in its operations.

(d)        Tax Benefits: Since the entire lease rental is treated as expenditure, cost of the asset is amortised rapidly under this option, and hence there is huge tax savings, when compared to similar cash outflow under the borrowing and purchasing option.

 

Lease vs. Buy Option

There is no denying the fact that leasing will never entail ownership of asset to the lessee. However, in case of a finance lease that transfers substantially all the risks and rewards incidental to ownership of an asset, such issue may not be that significant as the lessee continues to enjoy all the benefits associated with the asset for almost the entire lifetime of the asset. Hence, the issue that concerns most is the cost. In order to make a comparative analysis all the relevant cash flows are required to be identified. In addition, any tax savings shall also be taken into consideration. Following is a summary of all the cash flows and tax shields associated with the two options:

 

Buy Option (Through Loan)	Lease Option
PV of instalments against the loan taken to buy the asset	PV of after-tax lease rentals
PV of interest tax shield	PV of after-tax maintenance cost, if any
PV of depreciation tax shield
PV of after-tax maintenance cost
PV of residual value of the asset, if any

 

Break-Even Lease Rental (BELR)

BELR of Lessee

While evaluating a lease-or-buy option, a lessee often looks for a lease rental for which both the lease and the buy option will yield equal amount of cash outflow. Such a lease rental is known as Break-Even Lease Rental (BELR). In other words, the BELR is the rental at which the lessee remains indifferent to a choice between leasing and buying. Thus, it is the maximum amount of lease rental that the lessee will be willing to pay. Therefore, if the actual amount of lease rental is less than or equal to the BELR, the lessee will accept the lease. Otherwise, the same will be rejected.

 

Mathematically, if BELR of lessee is ‘L’, value of ‘L’ will be such that

PV of cash outflows as after-tax lease rentals (L) + PV of after-tax maintenance cost, if any, as per the lease agreement

= PV of cash outflows under buy (through loan) option

= PV of Instalments – PV of Interest Tax Shield – PV of Depreciation Tax Shield – PV of Salvage Value of the Asset, if any + PV of after-tax maintenance cost

 

BELR of Lessor

From the view point of a lessor, however, the concept of BELR is different. Here, BELR is the minimum lease rental that the lessor can accept. Therefore, the lease rental to be quoted by the lessor to the lessee for accepting a lease proposal will be more than or equal to the BELR.

 

Mathematically, if BELR of lessor is ‘L’, value of ‘L’ will be such that

PV of cash inflows as after-tax lease rentals (L)

= Cost of the asset – PV of Depreciation Tax Shield – PV of Salvage Value of the Asset + PV of after-tax maintenance cost, if any, as per the lease agreement

 

Leveraged Lease and BELR of Lessor

Leveraged lease refers to a lease agreement wherein the lessor acquires an asset partially financed by the financial institutions and lease out the same to the lessee for the agreed lease payments. The lessee transfers the lease rentals directly to an escrow account maintained with the financial institution by the lessor. The financial institution charges the loan instalments (principal plus interest) from the proceeds available in the escrow account and balance amount, if any, gets transferred to the account of the lessor.

 

In case of leveraged lease, the lessor must determine the minimum lease rental (i.e. BELR) to recover the equity portion (financed by own fund) of the cost of the asset as well as the loan instalment by the net cash inflows in the form of after-tax lease rentals.

Part B

Strategic Financial Management

Lease Financing

Selected Problems and Solutions

 

Illustration: 1

 

XL Transport Ltd. needs a truck for which it is considering the following two options:

   (i)        Buy the asset for Rs 3, 00,000 by borrowing the amount @ 12% interest and repaying the same together with interest in 4 equal annual instalments.

(ii)        Acquiring the asset on lease with a payment of annual lease rentals of Rs 90,000 per annum for 4 years.

 

The firm follows straight line method of depreciation and is under the income tax bracket of 30%. Life of the asset is 4 years.

 

Which option – lease or buy, should the firm opt for?

 

Solution: 1

 

Illustration: 2

 

Excel Transport Ltd. needs a truck for which it is considering the following two options:

   (i)        Buy the asset for Rs 3, 00,000 by borrowing the amount @ 12% interest and repaying the same together with interest in 4 equal annual instalments.

(ii)        Acquiring the asset on lease with a payment of annual lease rentals for 4 years.

 

The firm follows straight line method of depreciation and is under the income tax bracket of 30%. Life of the asset is 4 years.

 

What is the maximum amount of annual lease rental the lessee will be willing to pay for accepting the lease?

 

Solution: 2

 

Illustration: 3

 

ABC Finance Ltd., a leasing company, has been approached by a prospective customer intending to acquire a machine whose cash down price is Rs 6 Crores. The customer, in order to leverage his tax position, has requested a quote for a four-year lease with rentals payable at the end of each year in a diminishing manner such that they are in the ratio of 4: 3: 2: 1. Depreciation can be assumed to be on straight line basis and ABC Finance Ltd’s marginal tax rate is 30%. The target rate of return for ABC Finance Ltd. on the transaction is 10% p.a. The asset has no salvage value.

 

Solution: 3

Illustration: 4

 

P Ltd. has taken a plant on lease, valued at 40 Crores. The lease arrangement is in the form of a leveraged lease. K Ltd. is the equity participant and H Ltd. is the loan participant. They invest fund in the ratio of 1: 4. The loan from H Ltd. carries a fixed rate of interest of 15%, payable in 6 equated annual instalments. The lease term is 6 years, lease rentals being payable annually in arrears.

 

(a)        Compute the equated annual instalment from the point of view of H Ltd.

(b)        If the lease rent is unknown, and K Ltd’s pre-tax yield is 20%, what is the minimum lease rent that must be quoted?

 

Solution: 4

 

Illustration: 5

 

Lessor charges Rs 5,000 annually, paid directly to the lessor at the start of each year.

Lease commencement date: 1/1/2020

Lease end date: 31/12/2024

Lease term: 5 years

The fair value of the tractor at the time of lease commencement: Rs 20,000

The lessor expects the fair value of the tractor at the end of the 5-year lease term (the unguaranteed residual value) will be Rs 1,000.

The lessor incurs initial direct costs of Rs 1,500.

Calculate the interest rate implicit in the lease.

 

Solution: 5

 

Illustration: 6

 

Fair Finance, a leasing company, has been approached by a prospective customer intending to acquire a machine whose cash down price is 3 Crores. The customer, in order to leverage his tax position, has requested a quote for a 3-year lease with rentals payable at the end of each year in a diminishing manner such that they are in the ratio of 3: 2: 1. Depreciation can be assumed to be on straight line basis and Fair Finance’s marginal tax rate is 35%. The target rate of return for Fair Finance on the transaction is 12%.

 

Calculate the lease rents to be quoted for the lease for three years.

 

Solution: 6

 

Illustration: 7

 

ABC Company Ltd. is faced with two options as under in respect of acquisition of an asset valued Rs 1, 00,000:

Either

  1.        To acquire the asset directly by taking a Bank Loan of Rs 1, 00,000 at 15% interest repayable in 5 equal year-end instalments together with interest.

Or

  2.        To lease in the asset at yearly rentals of Rs 320 per Rs 1,000 of the asset value for 5 years payable at year end. The following additional information are available:

                    (a)        The rate of depreciation of the asset is 15% under WDV method.

                    (b)        The Company has an effective tax rate of 50%.

                     (c)        The Company employs a discounting rate of 16%.

 

You are to indicate in your report which option is more preferable to the Company. Restrict your calculation over a period of ten years.

 

Solution: 7

 

Illustration: 8

 

Elite Builders has been approached by a foreign embassy to build for it a block of six flats to be used as guest houses. As per the terms of the contract, the foreign embassy would provide Elite Builders the plans and the land costing Rs 25 lakhs. Elite Builders would build the flats at their own cost and lease them to the foreign embassy for 15 years at the end of which the flats will be transferred to the foreign embassy for a nominal value of Rs 8 lakhs. Elite Builders estimates the cost of construction as follows:

Area per flat: 1,000 sq. feet; Construction cost: Rs 400 per sq. feet; Registration and other costs: 2.5% of cost of construction; Elite Builders will also incur Rs 4 lakhs each in years 14 and 15 towards repairs.

 

Elite Builders proposes to charge the lease rentals as follows:

Years	Rentals
1 – 5	Normal
6 – 10	120% of normal
11 – 15	150% of normal

 

Elite Builders’ present tax rate averages at 35% which is likely to be the same in future. The full cost of construction and registration will be written off over 15 years at a uniform rate and will be allowed for tax purposes.

 

You are required to calculate the normal lease rental per annum per flat. For your exercise, you may assume:

(a)        Minimum desired return of 10%,

(b)        Rentals and repairs will arise on the last day of the year, and

 (c)        Construction, registration and other costs will be incurred at time = 0.

 

Solution: 8

 

Illustration: 9

 

Basic information:

     1)        Asset related: Cost Rs 120 lakhs; Rate of depreciation 40% under WDV method; Useful life 4 years; Residual value after 3 years Rs 25.92 lakhs.

     2)        Leasing option: Full pay out; Three-year lease; Lease quote Rs 434 per Rs 1,000; Payment annually in arrears.

     3)        Borrow and buy option: Three-year loan; Interest rate 15%; Quantum to be determined such that annual repayment of principal will be equal to annual lease rental payment.

     4)        Other: Tax rate is 40%; Opportunity cost of capital is 11%.

 

Based on the information given above, determine the preferred option as between leasing and buying.

 

Solution: 9

 

Illustration: 10

 

PQR Ltd. is considering acquiring an additional computer to supplement its time-share computer services to its clients. It has two options:

      1.        To purchase the computer for Rs 22 lakhs.

      2.        To lease the computer for three years from a leasing company for Rs 5 lakhs as annual lease rent plus 10% of gross time-share service revenue. The agreement also requires an additional payment of Rs 6 lakhs at the end of the third year. Lease rents are payable at the year-end and the computer reverts to the lessor after the contract period.

 

The company estimates that the computer under review will be worth Rs 10 lakhs at the end of third year.

 

  Forecast revenues are:

Year	1	2	3
Amount (Rs in lakhs)	22.5	25	27.5

 

Annual operating costs excluding depreciation/lease rent of computer are estimated at Rs 9 lakhs with an additional Rs 1 lakh for start-up and training costs at the beginning of the first year. These costs are to be borne by the lessee. Your company will borrow at 16% interest to finance the acquisition of the computer. Repayments are to be made according to the following schedule:

Year	1	2	3
Principal (Rs in ’000)	500	850	850
Interest (Rs in ’000)	352	272	136

 

The company uses straight line method (SLM) to depreciate its asset and pays 50% tax on its income. The management approaches you to advice which alternative should be recommended and why?

 

Note: PV Factors at 8% and 16% discount rate are:

Year	1	2	3
8%	0.926	0.857	0.794
16%	0.862	0.743	0.641

 

Solution: 10

 

Illustration: 11

 

R Ltd., a profitable company is considering the purchase of a new machine for Rs 75 lakhs. The machine’s useful life is 5 years, with annual maintenance, insurance and administration costs of Rs 12 lakhs. Depreciation is over its life on straight line basis, considering zero scrap value. The tax rate is 30%. R Ltd. has a capital structure of 60% debt and 40% equity. Cost of debt before tax is 8% and the cost of equity is 12%. R Ltd. is interested in leasing out this machine to a lessee ‘L’ on year-end annual lease rents and R will have to maintain the equipment at the costs stated above.

 

What should be the lease rents to be billed to ‘L’ for the lease proposal to break-even if:

   (i)        R Ltd. acquires the machine from its total finance pool.

(ii)        R Ltd. uses a bank borrowing specifically for this purpose at 10% interest rate on outstanding principal at the beginning of each year, with year-end instalments comprising Rs 15 lakhs towards principal and balance towards interest for the year?

 

Present calculations to the nearest rupee.

 

Solution: 11