CHAPTER 22
ASSET-BASED : LEASE, HIRE PURCHASE
AND PROJECT FINANCING
LEARNING OBJECTIVES
2
Define
lease and highlight its true advantages
Explain the methods for evaluating a lease
Discuss the concept of a leveraged lease
Highlight the difference between hire purchase
financing and lease financing
Focus on project financing as a special mechanism
for financing large projects
Lease Defined
3
Lease
is a contract under which a lessor, the owner of the
assets, gives right to use the asset to a lessee, the user of
the assets, for an agreed period of time for a consideration
called the lease rentals.
In up-fronted leases, more rentals are charged in the initial
years and less in the later years of the contract. The
opposite happens in back ended leases.
Primary lease provides for the recovery of the cost of the
assets and profit through lease rentals during a period of
about 4 or 5 years. It may be followed by a perpetual,
secondary lease on nominal lease rentals.
Types of Leases
4
1.
2.
3.
Operating Lease
Financial Lease
Sale-and-lease-back
Operating Lease
5
Short-term,
cancelable lease agreements are called
operating lease.
Tourist renting a car, lease contracts for computers,
office equipments and hotel rooms.
The Lessor is generally responsible for maintenance
and insurance.
Risk of obsolescence remains with the lessor.
Financial Lease
6
Long-term,
non-cancelable lease contracts are known
as financial lease.
Examples are plant, machinery, land, building, ships
and aircrafts.
Amortise the cost of the asset over the terms of the
lease–Capital or Full pay-out leases.
Sale and Lease Back
7
Sometimes,
a user may sell an (existing) asset owned by him
to the lessor (leasing company) and lease it back from him.
Such sale and lease back arrangements may provide
substantial tax benefits.
In April 1989, Shipping Credit and Investment Corporation of
India purchased Great Eastern Shipping Company bulk
carrier, Jag Lata, for Rs 12.5 Cr and then leased it back to
GESC on a 5 years lease, the rentals being Rs 28.13 Lakh per
month. The ships WDV was Rs 2.5 Cr.
Cash Flow Consequences of a Financial Lease
8
Avoidance
of the purchase price
Loss of depreciation tax shield
After–tax payments of lease rentals
Commonly Used Lease Terminology
9
1.
2.
3.
4.
5.
6.
7.
8.
9.
Leveraged Lease
Cross-border lease
Closed and open ended lease
Direct lease
Master lease
Percentage lease
Wet and dry lease
Net net net lease
Update lease
Myths about Leasing
10
Leasing
Provides 100% Financing
Leasing Provides Off-the-Balance-Sheet Financing
Leasing Improves Performance
Leasing Avoids Control of Capital Spending
Advantages of Leasing
11
1.
2.
3.
Convenience and Flexibility
Shifting of Risk of Obsolescence
Maintenance and Specialized Services
Evaluating a Lease
12
Equivalent
Loan Method
Net Advantage of a Lease Method
IRR Approach
Equivalent Loan Method
13
EL is that amount of loan
which commits a firm to
exactly the same stream
of fixed obligations as
does the lease liability.
Method—
1.
2.
3.
Find out incremental cash
flows from leasing.
Determine the amount of
equivalent loan such cash
flow can service.
Compare the equivalent
loan so found with lease
finance.
Net Present Value and Net Advantage of
Leasing
14
The direct cash flow consequences are:
1.
2.
3.
The purchase price of the asset is avoided.
The depreciation tax shield Is lost.
The after tax lease rentals are paid.
The net present value of these cash flows at
after tax cost of debt should be calculated. If it
is positive, lease is beneficial.
Combination of Net Present Value of Investment and
Net Advantage of Leasing
15
Lease Benefits to Lessor and Lessee
16
A
lease can benefit both when their tax rate
differs.
Leasing pays if the lessee’s marginal tax rate is
less than that of the lessor. In fact in a lease, the
lessee sells his depreciation tax shield to the
lessor.
In the absence of taxes it is hard to believe that
leasing would be advantageous if the capital
markets are reasonably well functioning.
Gain of both is loss to the government in form of
taxes.
Leasing Benefits Come from…
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lessor and lessee, gain at government’s expense
because of the difference in their tax rates.
The government gains from the tax on lease rentals
while it loses on depreciation and interest tax shields.
The implicit principal payments in a lease rental are
shielded by depreciation, while interest deductions
provide for implicit return on the lessee’s capital.
Both,
Net Advantage of a Lease (NAL) including
Operating Costs and Salvage Value
18
Internal Rate of Return Approach
19
IRR of a lease is that rate which makes NAL
equal to zero.
1.
2.
3.
4.
5.
6.
Ao = Purchase Price.
L
= Lease Rentals.
DEP = Depreciation
T
= Tax Rate
OC = Operating Cost
SV = Salvage Value
n
Ao
t 1
1 T L OC
1 r
t
t
TDEPt
SV n
1 r
n
0
DEPRECIATION TAX SHIELD AND
SALVAGE VALUE UNDER INDIAN TAX LAWS
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Once
the firm sells an asset, it will know the
salvage value on which it will lose the depreciation
tax shield.
Thus, the lost depreciation tax shield on salvage
value should be treated as safe cash flows and it
would be discounted at the after-tax cost of
borrowing.
LEVERAGED LEASE
21
Hire Purchase–Conditions
22
The
owner of the asset (the Hirer or the manufacturer) gives the
possession of the asset to the Hirer with an understanding that
the Hirer will pay agreed instalments over a specified period of
time.
The ownership of the asset will transfer to the hirer on the
payment of all instalments.
The Hirer will have the option of terminating the agreement any
time before the transfer of ownership of assets. ( Cancellable
Lease)
Hire purchase financing
Difference between Leasing and Hire Purchase
Financing
23
Instalment Sale
24
Instalment
Sale is a credit sale and the legal
ownership of the asset passes immediately to the
buyer as soon as the agreement is made between
the buyer and the seller.
Except for the timing of the transfer of
ownership, instalment sale and hire purchase are
similar in nature.
Evaluation of Hire Purchase Financing
25
The
hiree charges interest at a flat rate, and he
requires the hirer to pay equal instalments at each
period.
The sum-of-years-digit (SYD) method is the most
commonly used methods for calculating interest
over a period of time.
Project Financing
26
Scheme
of financing a particular economic unit in
which a lender is satisfied in looking at the cash
flows and the earnings of that economic unit as a
source of funds, from which a loan can be repaid
and to the assets of the economic unit as a collateral
for the loan.
It is different from the traditional form of financing,
i.e., the corporate financing or the balance sheet
financing.
Balance sheet financing vs. Project financing
27
Characteristics
28
1.
2.
3.
4.
5.
6.
Separate project entity
Leveraged financing
Cash flows separated
Collateral
Sponsor’s guarantees
Risk sharing
Project financing allows sponsors to:
29
projects larger than what the company’s
credit and financial capability would permit,
Insulate the company’s balance sheet from the
impact of the project,
Use high degree of leverage to benefit the equity
owners.
Finance
Financing Arrangements for Infrastructure
Projects
30
1.
2.
3.
The Build Own Operate Transfer (BOOT)
Structure.
The Build Own Operate (BOO) Structure.
The Build Lease Transfer (BLT) Structure.
31
BOOT/BOO Structure of a Power Plant
32
The Built-Lease-Transfer (BLT) Structure
Project Financing Risk and their Allocation
33
Risks
1.
2.
3.
4.
Project Completion Risk
Market Risk
Foreign Currency Risk
Inputs Supply Risk
Risk Mitigation
1.
By Government
1.
2.
3.
Country Risk
Sector Policy Risk
Commercial Risk
Financial Structure of Infrastructure
Projects
34
Debt
Bonds
Equity
Appropriate Return to Equity and Financial
Structure in Infrastructure Project Financing
35
Return
on equity
Risk measurement
Impact of guarantees
Financial structure
Taxes
Financial distress
Government restrictions
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