Better Evaluation of a Lease
V Raghunathan
In the October-December 1986 issue, Vikalpa published an article on leasing by
I M Pandey who outlined an approach to
lease evaluation, treating leasing as functionally equivalent to debt and using the
borrowing rate for discounting cashflows.
V Raghunathan argues in this article
that treating leasing as functionally equivalent to debt is flawed. He outlines an
investment approach to evaluating a lease
using the weighted average cost of capital
for discounting instead of the borrowing
rate. In addition to outlining his approach, Raghunathan comments on the
Indian leasing scene and on the myths
and realities about leasing.
V Raghunathan is Associate Professor
in the Finance and Accounting Area at
the Indian Institute of Management,
Ahmedabad.
Literature on leasing is beginning to multiply in
India as fast as the number of leasing companies
themselves. Unfortunately, this growth in literature seems to be adding to the general confusion
rather than abating it. The article by I M Pandey
titled "Myths and Realities about Leasing" (Vikalpa, October-December 1986), though lucidly
written, fails to clear the confusion. The approach
used and the conclusions drawn by him are
flawed.
In this article, I critique the approach used by
Pandey and outline a better approach to lease
evaluation that envisages a useful economic role
for leasing, and comment on the Indian leasing
scene. The myths and realities about leasing narrated by Pandey are misleading. In Box 1, I have
commented on these myths under the heading
"More on the Myths and Realities about
Leasing."
Approach to Lease Evaluation
Pandey uses the same discount rate for both lessor and lessee, namely the going rate of interest
for long term funds in the market. This approach
provides no economic role to leasing other than
as a market for trading in tax shields, resulting in
a joint minimization by lessor and lessee of their
tax.
In this approach, leasing has no role to play
when both lessee and lessor profit by the transaction. If both profit and absorb their respective tax
shields in the period in which they accrue, both
will have the same discount rate, namely the
after-tax interest rate (say r(l—T), where r is the
interest rate and T is the corporate tax rate). Also
cashflows for the two' are identical except that
inflow for one is outflow for the other and vice
versa. Thus, the net advantage of leasing (NAL) for
one would imply a net disadvantage of leasing for
the other. This implies that leasing can never be
acceptable to both when both have profitable operations (except when both are indifferent, NAL being
zero).
In this approach, therefore, leasing has no internal economic justification since the lessor is always assumed to be loss making, which is the
raison d'etre for a lease deal to be acceptable to
both. Such a position is untenable simply because
no activity which presupposes losses is worth undertaking in the first place.
What should then be the correct approach to
lease evaluation? To answer this question, it is
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necessary to take a closer look at the differences in
the perspectives of the lessee and lessor to lease
evaluation.
Lessee's Perspective
Let us assume that a profitable firm is considering
the acquisition of a capital asset. Assuming that
the objective of the firm is to maximize wealth for
its shareholders, its decision making process may
be viewed as follows: If the present value of the
net operating cashflows (accuring from the deployment of the asset) when discounted at the
overall cost of capital of the firm (in order to ensure maximization of wealth to its shareholders)
Vikalpa
r = cost of borrowings, i.e. the interest
rate
D:E = the target debt to equity ratio for the
firm, based on market value, since
the firm's objective function, viz. the
shareholders' wealth, is determined
only at the market place.
It should be noted that in the above approach the
tax shield on interest is captured in the discount
rate rather than in cashflows. Alternatively, the tax
shield on interest may be captured in cashflows
rather than in the discount rate. The latter
approach is especially suited to situations where
the tax shield on interest may not be absorbed in
the year in which it accrues.
Lessee's Decision
Now, the decision would be to lease the asset if
NPV1 > NPVp > 0, and buy the asset if NPVp >
NPV1 > 0. Alternatively, if NPV1 — NPVD be referred to as the net advantage of lease (NAL), we have
the decision rule:
Lease if NAL > 0 and NPV1 > 0 and
Purchase if NAL < 0 and NPVp > 0
Thus the asset should be leased if both the net
advantage of leasing and the net present value of
the lease are positive. The asset should be
purchased if the net advantage of leasing the asset
is negative and the net present value of the purchase option is positive.
The net advantage of leasing (NAL) is given by
NAL = equation (1) — equation (2)
By equating NAL to zero, one may solve the equation for L, which would yield the breakeven rental
or the maximum rental that the firm would be prepared to pay the lessor, so as to be indifferent between the buy and lease options.
Lessor's Perspective
At this point it becomes obvious that the lessor's
40
approach to the lease evaluation would also be
identical to equation (4) except that the cashflows
would have the opposite signs and, more importantly, would have a different discount rate, i.e.
the lessor's weighted average cost of capital. Thus,
the lessor would decide to lease if NAL > 0 and not
lease if NAL < 0. It should be noted that NPVp and
NPV1 are irrelevant to the lessor, since his earnings do not come from the deployment of the asset.
Therefore, the only decision relevant to him is
whether to lease or not to lease the asset. Here it is
assumed that the lessor would actually invest in
the asset only if he can lease it.
The differences in the perspective to leasing
of the lessee and the lessor can be summarized as
below:
An important difference in the perspective between
the lessee and the lessor arises because the same
terms of a lease have different values for them. This is
because of differences in their costs of capital. While
the average debt to equity ratio in India of a lessee is
2:1, that of a lessor is typically upwards of 6:1.
Approximations and Errors
In employing equation (4) for lease evaluation, it
should be recognized that rental cashflows are
monthly or quarterly, whereas tax shields are normally realized only on a quarterly or annual basis.
Thus to arrive at NAL or breakeven lease rental,
annual cashflows are discounted at the annual
rate, whereas monthly or quarterly cashflows are
discounted at equivalent (time adjusted) ^onthly
or quarterly rate. In a casual treatment, however,
the monthly discount rate is arrived at by merely
dividing the annual discount rate by 12.
This would be obviously erroneous, since this
treatment disregards the time value of money. It is
surprising that, in a carefully illustrated article,
Pandey overlooks the importance of accuracy in
Vikalpa
this regard. Such casual treatment of discount
rate can impart a considerable degree of error in
arriving at the breakeven lease rental. This has
been illustrated in Box 2 under the heading "On
the Hazards of Approximation."
Box 2
On the Hazards of Approximation
When annual cashflows are discounted by an annual rate, say r, the time-adjusted equivalent
monthly rate rm for discounting the monthly
cashflows is given by
rm = (l+r)1/12 - 1
Similarly, the equivalent quarterly discount rate rq
is given by
r q = (1 + r) 1 / 4 - 1
and so on.
Instead of using these formulas, the casual approximation generally used is to divide the annual
rate by 12 to get the monthly rate and to divide it by
4 to get the quarterly rate. This may be too gross an
approximation.
To appreciate the extent of difference, breakeven monthly lease rentals have been calculated for
the example employed by Pandey in his paper, using time-adjusted rate and the casual
approximations.
Let
Acquisition cost of asset: Rs 1000
Period of lease: 8 years
Depreciation rate: 30 per cent
Salvage value: 0
Annual discount rate: 6.75 per cent
Unadjusted monthly discount rate: 6.75/12
= 0.5625 per cent
Time adjusted equivalent
monthly
discount rate: (1.0675)1/12 —1= 0.5458 per
cent
Using the unadjusted discount rate of 0.5625
per cent Pandey arrives at a monthly breakeven
rental of Rs 16.43. However, when the time adjusted
monthly discount rate is used, with due regard to
the fact that lease rentals are monthly while tax
shields are not, the monthly breakeven rental works
out to Rs 15.20. There is a difference of Rs 1.23 per
Rs 1000 of asset. It should be clear that, in dealing
with time value, casual approximations introduce a
very high degree of error. What is more, this error
increases as the discount rate increases. When
amounts involved are large, as in leasing, such approximations can be hazardous.
Similarly, one must guard against the tempfation to divide the annual breakeven rental by 12 to
arrive at the monthly breakeven rental.
Vol. 12, No. 2, April-June 1987
Breakeven Lease Rentals
Using the above framework, we may now work out
the breakeven lease rentals for a typical lessor and
lessee in the Indian context. We shall make the
following assumptions:
Lessor's debt to equity ratio
6:1
Lessee's debt to equity ratio
2:1
Cost of equity for lessee and
lessor
30 per cent
Cost of debt for lessor
(being largely public deposits) 13.5 per cent
Cost of debt for lessee
18 per cent
Tax rate
50 per cent
Using equation (3), these parameters imply a
weighted average cost of capital of about 10 per
cent for the lessor and 16 per cent for the lessee.
For the above two discount rates, Table 1 gives
the monthly breakeven lease rentals for
Rs 1000 worth of an asset for 5 and 8 year leases for
different depreciation rates and salvage values.
From Table 1, we see that, when the salvage
value of the asset is assumed to be zero and depreciation rate is say 30 per cent, the minimum
monthly lease rent which the lessor (with a discount rate of 10 per cent) would need to receive is
Rs 24.31 in order to break even on the deal. For the
same parameters, the maximum monthly lease rent
which the lessee (with a discount rate of 16 per
cent) can afford to pay in order to be indifferent
between his lease and buy options would be
Rs 28.73. In such a case any leasing transaction
between the lessor and the lessee at a monthly rent
ranging between Rs 24.31 and Rs 28.73 per Rs
1000 of the asset would be advantageous to both.
In other words, within this rental band NAL for
both the lessor and the lessee will be positive.
Determinants of Leasing Economics
It is clear that when both lessee and lessor have
exactly opposing cashflows, are in the same marginal tax rates, are able to absorb their tax shields,
and have identical discount rates, no lease deal
would be struck on economic criteria since NAL
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loser to the extent of the difference. However, the
government presently allows tax shield on depreciation to the lessor at a lower tax rate as compared
to the rate it allows to the lessee if he purchased
and used the asset. On this count the government
benefits to the extent of the difference. Thus,
whether on the whole a lease deal is struck at the
cost of the government would depend on the relative values of the tax impacts concerning lease
rentals and depreciation to the government. However, even when both the lessee and the lessor
have the same discount rate and enjoy the same
marginal tax rate (largely true for Indian companies, except for the difference between the
marginal tax rates for the closely versus widely
held companies), tax advantages of leasing may
still be forthcoming to both if the lessor had unabsorbed accumulated losses so that the tax impacts
were shifted to future with resultant smaller NAL.
Only under this situation the government may really lose out in the form of lost taxes, even as the
deal benefits both. Even when this situation prevails, the correct approach for lease evaluation is
to adjust the cashflows for deferred tax shields and
not the discount rate as done by Pandey.
Further, from Tables 1 and 2 we can see that
the spread between the breakeven rentals of the
lessor and the lessee are also affected by changes
in depreciation rate, salvage value, and tax rate,
even if the discount rates of the lessor and the
lessee are unchanged.
Thus, the determinants of leasing economics
may be summed briefly below:
• the differential costs of capital of the lessor and
the lessee
• marginal tax rates of the lessor and lessee
• unabsorbed taxes of the lessor and the lessee
• governmental policies on taxation and depre
ciation
• market factors affecting the asset's salvage
value for the lessor and the lessee.
Indian Leasing Scene
Lease Undefined
Though considerable strides have been made by
the leasing industry in India in recent years, the
Vol. 12, No. 2, April-June 1987
uninitiated would be shocked to know that "leasing" as understood in the present day is as yet
undefined in Indian law. In fact the "definition"
for leasing can only be arrived at by negation of
other legal definitions. For instance, in order to
prove a transaction as a lease transaction for tax
purposes, it may often be necessary for one to ensure that the transaction in question is not a
"sale" or "hire purchase" or some other form of
"transfer of property" so that, by default, the
transaction is regarded a "lease." It is, however,
to the credit of Indian enterprise that a fairly
workable "definition" of a lease has tacitly come
to be agreed upon by all concerned, thanks
primarily to the First Leasing Company of India
Ltd. I have outlined the position with regard to
lease definition in Box 3 under the heading "Archaic Origins of Definition of Lease in India."
Low Rentals: Short Term and
Long Term Considerations
Notwithstanding the lack of leasing legalities,
there are upward of 600 leasing companies in India today. Perhaps a good many of them are mere
traders in unabsorbed losses. However, the sharp
spurt in the number of leasing companies from
less than 10 in 1982 to nearly 600 today is widely
said to have depressed the lease rentals below
what may be healthy for the leasing industry. To
see the veracity and the extent of truth in this
contention, let us revert to Table 1. For a depreciation rate of 30 per cent, the table indicates that
the breakeven monthly rental for a lessor, with a
discount rate of 10 per cent, is Rs 24.31. In other
words, on any particular lease deal, the lessor
must receive a minimum rental of Rs 24.31 per
Rs 1000 of asset in the short run so as to recover
his marginal costs.
In the long run, however, the lessor must recover not only his marginal cost on a specific
lease deal but also his fixed overhead costs from
rentals. Assuming a 5 per cent share of overheads
in lease rentals, over a period of time the lessor
must receive a rental of Rs 24.30 X 1.05 =
Rs 25.50 per month on a Rs 1000 asset for a fiveyear lease. Evidently, the current rentals in the
market are much lower at about Rs 23.24 for comparable parameters, despite the fact that the
breakeven rental for the lessee (with a discount
43
rate of 16 per cent) is much higher at Rs 28.73. In
other words, even if the lessor were to charge a
rental higher than Rs 25.50 it would still be affordable by the lessee, given our assumed parameters,
so long as the rental was kept below Rs 28.71. This
indicates that the current lease rentals in the industry are indeed low, although the market can
sustain higher lease rentals. How many companies
will survive if such low rentals continue is anybody's guess.
At the same time, it is interesting to note that
levying a sales tax of 5 per cent on lease rentals, as
is being done by more and more states, reduces the
spread available between the breakeven rental of
the lessor and the lessee further. For instance, a 5
per cent sales tax would imply that the breakeven rental of the lessor would be up again by 5
per cent, thereby making it Rs 26.75 (Rs 25.50 X
1.05), which leaves a narrower spread of just about
Re 1 for the lessor and the lessee to negotiate.
Clearly, there is little further scope for burdening
the leasing industry with any further taxation.
Further, the Indian leasing companies must
wake up to the fact that they are structurally very
different from their counterparts in the West
where most leasing companies are often merely
extended arms of banks. The situation is quite different for the private leasing companies in India
which are intermediaries between financiers and
ultimate users of money. It is rather difficult for a
private leasing company to have as low a cost of
capital as that of a financial institution and hence
it can scarcely afford to match such a low rental
structure. Entry of banks into leasing makes the
situation only worse for private leasing
companies.
Discount Rate: Caution Against
Using the Rate of Interest
By now, it can be readily seen that lowering the
discount rate lowers the monthly breakeven lease
rent. It is, therefore, tempting to believe that, in
addition to reasons of growing competition,
perhaps use of the interest rate as the discount rate
for leasing evaluation may also be responsible for
the low level of rentals in the Indian market. Even
if the leasing industry does not consciously use
the interest rate for discounting for purposes of
Vikalpa
lease evaluation, the same effect is indirectly obtained when the leasing companies try to match
the rental structures of a financial institution like
ICICI which obtains its funds at about 12 per cent
a year and thus has an after-tax discount rate of 6
per cent. At 6 per cent discount rate, ICICI's short
term monthly breakeven rental is a mere Rs 21.30
(not taking into account the tax shield on investment allowance). Thus when ICICI quotes a rental
of Rs 23 on a five-year lease, the implicit rate of
return is merely 8.5 per cent after tax or 17 per
cent before tax, which is higher than its cost of
capital. One must recognize that a perpetual underestimation of breakeven rentals by the lessor
(when the lessee's approach is right) would lead
to acceptance of potentially unprofitable leases
by him. On the other hand, underestimating of
breakeven rentals by the lessee (when the lessor's
approach is right) may result in his buying the
assets which in fact he should have leased. However, given the current scenario when probably
both the lessor as well as the lessee may be underestimating their breakeven rentals, it should be
clear from the above analysis that the net loser
would be the lessor and not the lessee, since the
latter's actual breakeven rental at Rs 28.71 is
much higher.
Future for Indian Leasing
Unfortunately the bulk of leasing companies that
have sprung up lately have entered the fray with
an eye on the third determinant of leasing
economics, namely unabsorbed losses. Thus,
such leasing companies have deviated from their
true economic role as financiers and have become
mere traders in unabsorbed losses as is evidenced
by an increasing number of in-house leasing
firms and sale and lease-back deals. Also, more
often than not, manufacturers have been setting
up leasing companies just to circumvent their
Vol. 12, No. 2, April-June 1987
debt to equity ratio norms which is pegged at 2:1.
By setting up a leasing company, a manufacturer
indirectly enjoys a debt to equity ratio limit up to
10 : 1. It is in fact this tendency of Indian industry
to short circuit an otherwise economically relevant
and necessary activity which is abhorable and not
the activity of leasing per se. One should not be too
surprised if before long we see some legislation
curbing this tendency. Already the situation gives
rise to a feeling of deja vu: we have seen it happening in the treatment of manufacturing expenses, in
the context of capitalization of interest, and may
be (with some reservations) in the context of "zero
tax" companies. Already, the latest move by the
government requiring all companies to pay taxes
on 30 per cent of book profits is bound to be felt
particularly hard by the leasing companies, which
have wittingly or unwittingly been bookkeeping
their way to huge profits and paying large dividends in recent years. The mismatch that often
prevails between the asset's economic life and the
lease period easily affords the opportunity for
such shortsighted accounting policies.
In addition, most leasing companies are indiscriminately employing relatively short period
funds (public deposits) on long term leases of five
to eight years. High dividend payout in initial
years coupled with potential liquidity problems
in later years of the leasing business is bound to
set off the fuse which might well blow many a
leasing company to oblivion before one full cycle
of eight years of leasing is through. The leasing
industry may yet survive, but probably with far
fewer leasing companies than at present. The
economic role of leasing must extend far beyond
that of enabling trading in tax shields. Leasing is,
and must be, viewed as a further division of
labour: a specialized activity concentrating on
bringing suppliers and users of money together,
thereby more sharply differentiating and realigning risks and returns in the economy.
45