LEASING

An Overview

Characteristics

Periodical payment of rentals

Lessor Lessee Right to use an asset for

a fixed period of time

Ownership rests with the lessor

Term

Lease Period = Lease agreement is operational

Perpetual leasePrimary

Lease Period

Secondary

Tests for Financial Lease

Substance Test: Lessee Compliance with No.2 point

Full Payment Test: Lessor Compliance with No.8 point –

Transfer of Title Test: Lessee has an option to buy the asset

Lease Term Test: Lease term extends to the asset’s life

Myths about Leasing

Off-balance sheet financing

No evaluation for capital expenditure – Cash flow

consequences?

Better Performance – Possible to enhance ROI, but the transaction should yield a positive NPV

Advantages of Leasing

Advantages to the lessor:

1. Stable Business – Lessee’s continued patronage

2. Sale of spare parts

3. Second-hand market

4. Tax benefits

5. Fillip to capital market

6.Easy finance

Advantages of Leasing

Advantages to the Lessee:

1. Efficient use of funds - No capital investment

2. Cheaper Source - than buying option

3. Enhanced borrowing capacity - Lower D/E Ratio

4. Off-balance sheet borrowing - - do -

5. Tax benefits

6. Guard against obsolescence - Lessee can terminate the lease at any time and take up another asset under fresh lease

Limitations

Disguised form of debt financing Loss of depreciation tax shield, when depreciation

rates are high and leasing is preferred over buying Possibility of double sales tax in certain states Unfavourable capital gearing for the lessee No ownership Default Risk Working Capital not considered Indiscriminate finance

Tax Aspects of Leasing

Lessor: Deduction of depreciation from taxable income Income from lease rentals is taxable under “Profits and Gains

of Business and Profession” Deductible expenses:

Depreciation Rent, rates, taxes, repairs and insurance Amortization of preliminary expenses Interest on borrowed capital Bad debts All expenses incurred in furtherance of business Entertainment expenses (with a cap) Travel expenses (as per approved norms)

(See Illustration No.3.5 M Y Khan)

Lessee: Allowability of lease rentals – allowed as normal

business expenditure if they are not i. of capital nature, ii. Personal expense and relates only to the business purpose.

Deductibility of Incidental Expenses – Repairs, Maintenance, Insurance, Finance Charges,…(Incidental)

Installation expense (revenue expense in the year of incurrence)

Tax Planning

Lessee: Flexible Restructuring of Lease Rentals –

Substantial part of the lease rentals payable in the first year and a very small fraction during the remaining lease term

Lower rentals in earlier years and higher in later years depending on cash flows

Purely tax-driven structure of lease rentals not allowed by the IT authorities

(See Illustration No.3.6 M Y Khan) Transfer of Investment-related Unabsorbed Tax Shield –

Lessee firm enjoys 100% tax deduction (exports) – Tax shield on fresh capital investment would not have any impact on its cash flows – Tax shields can be transferred to the lessor who will consider lower lease rentals

(See Illustration No.3.7 M Y Khan)

Funding Aspects of Leasing

Deposits – Major source of finance Bank Borrowings –

Maximum Limit – 10 times of NOF including deposits, borrowings from banks/FIs, debentures, bonds

Maximum bank borrowings would be 3 times of NOF where 75% of the company’s assets are in equipment leasing and where 75% of its gross income is from leasing

NOF = Paid up Capital + Free Reserves – Accumulated balance of loss, where Free Reserves represent share premium account, capital and debenture redemption reserves and any other reserve not created for payment of any future liability or for depreciation in assets or for bad debts or a reserve created by revaluation of assets

RBI has freed the restrictions w.e.f.April 1997

Nature of Facility – based on the expected flow of lease rental receivables

Maximum Permissible Bank Finance – Calculate outstanding credit for next five years Calculate relevant Drawing Power against that particular

transaction Exclude – a. Funds raised from financial/inv. Institutions

b. DPGs provided by banks, and c. Assets created against DPGs issued by banks

This will imply bank finance will be to an extent of 2 – 3 times of NOF.

Requirements for Bank Finance Current Ratio – Minimum 1.33

Reports - (See page no. 203 Dr S Gurusamy)

Lessee’s Perspective of Leasing

Lease rental payments are similar to payments of interest on debt

Hence, alternative to borrowing Choice between debt financing versus lease financing Decision-criterion – Net Present Value of Leasing/Net

Advantage of Leasing – NPV(L)/NAL Discount Rate used is the marginal cost of capital for

all cash flows except lease payments and tax cost of debt for lease payments

Value of interest tax shield is included as a foregone cash flow in the computation of NPV(L)/NAL

NPV(L)/NAL

NPV(L)/NAL = Investment Cost

- PV of lease payment (discounted by Kd)- PV of tax shield on lease payment (discounted

by Kc)- Management Fee+ PV of tax shield on management fee (disc.by

Kc)- PV of Depreciation shield (discounted by Kc)- PV of Interest Shield (discounted by Kc)- PV of residual/salvage value (discounted by Kc)

Where Kc = Post-tax marginal cost of capital, and Kd = Pre-tax cost of long-term debt

NPV(L)/NAL negative means leasing alternative should be used.

NPV(L)/NAL positive means borrowing alternative would be preferable.

Alternative approach is Determine the PVs of cash outflows after taxes under both the

alternatives Select the alternative with the lower PV of cash outflows

(See Illustration No.4.1 M Y Khan)

Break-Even Lease Rental (BELR) for lessee

The point where the Net Advantage of Leasing (NAL) is zero.

The rental at which the lessee is indifferent between lease financing and borrowing/buying.

Maximum level of rental which the lessee is willing to pay

If the BELR > the actual rental, the lease proposal would be acceptable.

(See Illustration No. 4.4 M Y Khan)

Lessor’s Perspective of Leasing

Whether to accept a lease proposal, or to choose from alternative proposals

Determine break-even rental for the lessor, negotiation and fixation of lease rentals

(See Illustration No.4.5 M Y Khan)• BELR for a lessor – minimum lease rental which he

can accept• NAL/NPV(L) at this level of rental is zero.• Discount Rate to compute NAL is the marginal over-all

cost of funds to the lessor(See Illustration No. 4.6 M Y Khan)