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Module -5 Leasing

The document outlines the concepts of leasing, hire purchase, and project finance, detailing their definitions, types, and rationales. It explains various leasing types, including finance and operating leases, and discusses the financial implications of leasing versus purchasing assets. Additionally, it provides examples of leasing arrangements and hire-purchase agreements, emphasizing the financial decision-making involved in these transactions.

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7 views22 pages

Module -5 Leasing

The document outlines the concepts of leasing, hire purchase, and project finance, detailing their definitions, types, and rationales. It explains various leasing types, including finance and operating leases, and discusses the financial implications of leasing versus purchasing assets. Additionally, it provides examples of leasing arrangements and hire-purchase agreements, emphasizing the financial decision-making involved in these transactions.

Uploaded by

sutharmohini130
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Module – 5

Leasing, Hire
Purchase and
Project
Finance
Meaning

1. Lease: A lease represents a contractual arrangement whereby the lessor grants


the lessee the right to use an asset in return for periodical lease rental payments.

2. Hire Purchase: A hire-purchase involves, the purchase of an asset on the


understanding that the purchaser (called the hirer) will pay in equal periodic
installments spread over a length of time.

3. Project finance: Project finance is the principal arrangement for private sector
participation in infrastructure projects like power plants, airports, highways, and
telecommunication networks which depend heavily on debt.
Types of Lease
1. Finance Lease versus Operating Lease:
• Finance lease is a lease that transfers substantially the risks and rewards
incidental to ownership of an asset.
• The following conditions individually or in combination would normally lead to a
lease being classified as a finance lease.
 The lease agreement transfers ownership to the lessee when then lease expires.

 The lessee can purchase the asset at a bargain price when the lease expires.

 The lease term is for a major part of the asset’s life even of the title is not
transferred.
 The present value of lease payments is substantially all of the fair value of the
leased asset.
• An operating lease can be defined as any lease other than a finance lease.

• The salient features of an operating lease are.

 The lease term is significantly less than the economic life of the equipment.

 The lessee enjoys the right to terminate the lease at short notice without any
significant penalty.
 The lessor usually provides the operating know-how and the related services and
undertakes the responsibility of insuring and maintaining the equipment. Such an
operating lease is called a ‘wet lease’.
 An operating lease where the lessee bears the costs of insuring and maintaining
the leased equipment is called a ‘dry lease’.
2. Sale and Lease Back versus Direct Lease:
• In a sale and lease back transaction, the vendor of an asset sells the asset to a
leasing company, and leases it back in order to enjoy the uninterrupted use of
the asset in his business.
• The lease back arrangement in this transaction can be structured in the form of
either a finance lease or an operating lease.
• Usually manufacturing companies use this arrangement to unlock investment in
fixed assets such as factory buildings.
• A direct lease can be defined as any lease transaction which is not a “sale and lease
back” transaction.
• A direct lease usually is of two types: bipartite lease and tripartite lease.

• In a bipartite lease, there are two parties to the transaction—the equipment supplier-
cum-lessor and the lessee. The bipartite lease can be structured either as an
operating lease or as a finance lease with in – built facilities like upgradation of the
equipment (upgrade lease) or additions to the original equipment configuration.
• A tripartite lease, on the other hand, is a transaction involving three different parties—
the equipment supplier, the lessor, and the lessee. Most of the equipment lease
transactions fall under this category and are typically finance leases
3. Single Investor Lease versus Leveraged Lease
• In a single investor lease transaction, the leasing company (lessor) funds the
entire investment by raising an appropriate mix of debt and equity.
• The important point to be noted is that the debt funds raised by the leasing
company are without recourse to the lessee.
• Put differently, the lender cannot demand payment from the lessee in the event
of the leasing company defaulting on its debt servicing obligations.
• In a leveraged lease transaction, the leasing company or lessor (called the equity
participant) and a lender (called the loan participant) jointly fund the investment
in the asset to be leased to the lessee.
• The funding provided by the loan participant is usually structured in the form of a
fixed rate loan without recourse to the leasing company.
• Each lease rental received from the lessee is bifurcated into two parts: a part
which represents the debt service charge on the loan is passed on to the loan
participant and the balance which is passed on to the leasing company.
• The loan provided by the loan participant is secured by a first charge on the
future rentals payable by the lessee and a fixed charge on the leased asset.
4. Domestic Lease versus International Lease
• A lease transaction is classified as a domestic lease if all parties to the lease
transaction—the equipment supplier, the lessor, and the lessee —are domiciled in
the same country.
• A lease transaction is classified as an international lease if one or more of the
parties to the transaction is/are domiciled in a different country.
Rationale for Leasing
Plausible Reasons Dubious Reasons for Leasing
1. Convenience 1. Hundred Percent Financing
2. Benefits of Standardisation
2. Circumvention of Certain Controls
3. Better Utilisation of Tax Shields
3. Favourable Financial Ratios
4. Fewer Restrictive Covenants
5. Lower Cost of Obsolescence Risk
6. Expeditious Implementation
7. Matching of Lease Rentals to Cash
Flow Capabilities
Operating in Leases

Centaur Leasing is in the business of providing automobiles on a wet lease to corporate


clients. Centaur is considering a new model of Honda car for which a serious enquiry
has come from Moderna Enterprises. The cost of the vehicle is ₹ 1.2 million. Its
operating, maintenance, insurance, and other costs are expected to be ₹ 0.2 million in
year 1; thereafter it will increase annually by 8 percent. The car is expected to have a
useful life of 5 years and it will fetch a net salvage value of ₹ 0.4 million after that. The
depreciation rate for tax purposes will be 40 percent under the written down value
method. Centaur’s marginal tax rate is 35 percent and its cost of capital is 11 percent.
What annual lease rental should Centaur quote to Moderna Enterprises?
Post-tax Cash Flows Associated with the
Ownership and Operation of the Car
Centaur, of course, will have to charge an annual lease rental of more than ₹ 0.502
million for the following reasons:
(a) It has to cover the cost of negotiating and administering the lease contract
periodically.
(b) It has to forego revenues when the car is idle and off-lease.
(c) It has to bear the risk of the diminishing appeal of the car over a period of time.
Leasing as Financial Decision
Vitex Limited has decided to go for a fork lift for internal transportation. It costs ₹
10 million and has an economic life of 6 years at the end of which it will fetch a
net salvage value of ₹ 1 million. The fork lift will be depreciated at a rate of 40
percent per annum under the written down value method for tax purposes. The
marginal tax rate for Vitex is 35 percent. Vitex can borrow ₹ 10 million at
15.4 percent to buy the fork lift.
As the financial manager of Vitex, you have been approached by Anupam Leasing
which is willing to lease the fork lift for a lease rental of ₹ 2.4 million per year
payable in arrear. Vitex Limited will have to bear all operating, maintenance, and
insurance expenses.
If Vitex leases the fork lift rather than buys it, the financial implications are as
follows:
1. Vitex saves ₹ 10 million, the cost of the fork lift. This is equivalent to a cash
inflow of ₹ 10 million at the end of year 0.
2. Vitex, not being the owner of the fork lift, cannot claim depreciation on it.
Hence it loses the depreciation tax shield. Further, Vitex does not get the
salvage value after 6 years.
3. Vitex must pay ₹ 2.4 million per year to Anupam Leasing. The first payment is
due at the end of year 1.
4. The lease payment of ₹ 2.4 million per year represents a tax deductible
expense. Given a 35 percent marginal tax rate, the lease payments will
generate a tax shield of ₹ 0.84 million per year.
the NPV of lease is also referred to as the NAL (net advantage of lease) relative to
Internal Rate of Return
Equivalent Loan Amount

• The lease cash flow is:


Hire-Purchase Arrangement
Main features of a hire-purchase arrangement are as follows:
• The hiree (the counterpart of lessor) purchases the asset and gives it on
hire to the hirer (the counterpart of lessee).
• The hirer pays regular hire-purchase instalments over a specified period of
time. These instalments cover interest as well as principal repayment.
When the hirer pays the last instalment, the title of the asset is
transferred from the hiree to the hirer.
• The hiree charges interest on a flat basis. This means that a certain rate of
interest, usually around 8 percent, is charged on the initial investment
(made by the hiree) and not on the diminishing balance. The total interest
collected by the hiree is allocated over various years. For this purpose, the
‘sum of the years digits’ method is commonly employed.
Example
Nidhi Finance offers a hire-purchase proposal to one of its customers,
Synthetic Chemicals, which requires an equipment costing ₹ 1
million, on the following terms :
(i) a flat interest rate of 14 percent and

(ii) a hire-purchase period of 36 months.


Leasing v/s Hire Purchase

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