CHAPTER 22
ASSET BASED FINANCING: LEASE, HIRE PURCHASE AND PROJECT
FINANCING
Q.1
Define a lease. How does it differ from a hire purchase and instalment sale? What
are the cash flow consequences of a lease? Illustrate.
A.1
A lease is an agreement for the use of the asset for a specified rental. The owner
of the asset is called the lessor and the user the lessee. The leases are of two types,
i.e., (1) operating leases which are short term and cancellable, and (2) financial
leases which are long term non-cancellable. The most compelling reason for
leasing equipment rather than buying it is the tax advantage of depreciation which
can mutually benefit both the lessee and lessor. In India, lease can prove handy to
those firms which cannot obtain loan capital from normal sources. In the case of
lease, the company can acquire the asset without immediately paying for I;
depreciation is a deductible expenses; and lease rentals are also deductible
expenses, so it saves taxes.
Under a higher price arrangement, like in a lease, the hire purchaser is able to
avoid the payment for the purchase of the asset now, and instead pays higher
purchase instalments over a specified period and time as per agreement. The hire
purchaser becomes the owner of the asset once he has paid all instalments. Unlike
the lease, he is entitled to claim depreciation as well as the salvage value of the
acquired asset.
Hire purchase arrangements differ from instalment sale arrangement in terms of
the timing of ownership. Under hire purchase, ownership passes to the hire
purchaser on the payment of the last instalment, while under instalment sale
ownership is transferred once the agreement has been made between the buyer
and the seller.
Q.2
What are the myths and advantages of a lease?
A.2
A number of advantages, which really are myths, are claimed for a lease.
a) It is misconception about leasing that it provides 100% financing for the assets.
Most lease agreement require lease rentals in the beginning of the period. In
leasing, the firm acquires the asset and incurs the liability to make fixed
payments in future.
b) It is also myth that leasing provides off-the balance sheet financing. Leasing
affects the firm’s debt capacity; that is, its debt-servicing ability. Practically,
the contractual obligations of any form reduce the debt-servicing capacity of a
firm.
c) It is a myth that leasing absolves a firm from capital investment evaluation. It
also requires the screening of investments decision since a long term financial
commitments are to be made.
If a firm is incurring losses or making low profits, it cannot take the full
advantage of the depreciation tax shield on purchase of assets. It is, therefore,
sensible for it to let the leasing company (lessor) own the assets, take full
advantage of tax benefits, and expect that the lessor passes on at least some part of
the benefits in the form of low lease rentals. So, both parties, i.e., lessee and
lessor, may stand to gain financially (of course at the cost of government which
will lose tax revenues!).
Lease is suitable, if an asset is needed for a short period. It provides the flexibility
to tailor lease payments to the lessee’s cash flow.
Q.3
Explain and illustrate the equivalent loan method of lease evaluation.
A.3
Equivalent loan amount is that amount of loan which commits a firm to exactly
the same stream of fixed obligations as does the lease liability. This case flow can
be said to “service” the lease.
The equivalent loan instalment (EIL) method consists of the following steps for
evaluation of financial lease.
1) Find out incremental cash flows from leasing.
2) Determine the amount of equivalent loan such incremental cash flows can
service.
3) Compare the equivalent loan so found with lease finance.
4) If the lease finance is more than equivalent loan, the firm should finance
the asset by leasing.
The ELI is, in fact, the present value of lease cash flows and is given by following
equation.
Equivalent loan = PV of cash flows of a lease
n
(1 − T)L t + DTS
EL = ∑
(1 + i(1 − T)) t
t =1
Where T is tax rate; Lt is lease instalment; DTS is depreciation tax shield and
equals T × DEP; i is interest rate and t is time period of lease.
Q.4
What is net advantage of a lease? How is it calculated?
A.4
The net advantage of leasing is equal to the purchase price of the asset (avoided)
less present value of lease flows. The formula given above (see answer to Q 3) is
used to calculate net advantage of leasing. It denotes the incremental advantage
over the net present value of buying the asset through normal financing channels.
A positive net advantage of leasing does not imply that the assets should be
acquired, it implies advantage to leasing. So, before taking decision, net present
value of asset should be assessed as an investment. It is possible that leasing may
make a financially unattractive asset investment worthwhile.
Q.5
What is the difference between equivalent loan and net advantage of lease
methods of the lease evaluation?
A.5
Financial lease involves fixed obligations in the form of lease rentals. Thus, it is
like a debt and can be evaluated that way. Given the lease rentals and tax shields,
one can find the amount of debt which this cash flow can service. This is
equivalent loan. If equivalent loan is more than the cost of the asset, it is not
worth leasing the equipment. Lease evaluation can be done by calculating the net
advantage of lease. After-tax lease rentals and tax shields may be discounted at
the after tax borrowing rate while operating costs and salvage value at the firm’s
cost of capital to find out NAL. In the following formula, we assume that the
lessor will take care of the operating and maintenance expenses if the asset is least
instead of being ought.
n
NAL = Ao − ∑
t =1
(1 − T)L t + DTS t
[1 + i(1 + T )]
t
n
+∑
t =1
(1 − T )OC 1 ATSVn
−
(1 + k )
(1 + k ) t
Where Ao is the purchase price of the asset avoided, DTS is the depreciation tax
shield; T is the tax rate; i is the interest rate on borrowing; Lt is the lease
instalment; OC1 is the operating cost in year t avoided; k is the after-tax cost of
capital of the firm; and ATSVn is the after-tax salvage value of the leased asset at
the end of the life, n.
Q.6
“It makes sense for companies that pay no taxes to lease from companies that do”.
Explain.
A.6
A firm that is incurring losses or making low profits, it cannot take full advantage
of the depreciation tax shield on purchase of assets. It is, therefore, sensible for it
to let the leasing company (lessor) own the asset, take full advantage of two
benefits, and passes on some benefits in the form of reduced lease rentals to the
lessee. Both the lessor and lessee will gain financially.
Q.7
What is a leveraged lease? What are its merits and demerits?
A.7
Under a leveraged lease, four parties are involved: the manufacturer of the asset,
the lender from whom the lessor borrows a substantial portion of the assets
purchase price, the lessor and the lessee. In a leveraged lease, the lessor makes
substantial borrowing, e.g., 80% of the asset’s purchase price, and provides
remaining amount. The lessor claims all tax benefits related to the ownership of
the asset. Lenders, generally the large financial institutions, provide loans on a
non-recourse basis to the lessor. Their debt is serviced exclusively out of the lease
proceeds. The lessor mortgages the asset to the lenders.
The leveraged lease creates a high degree of leverage. It is quite useful for large
capital equipment with long economic life, say, 20 years or more.
Q.8
What is the hire purchase financing? How does it differ from the lease financing?
A.8
In hire purchase financing, there are three parties: the manufacturer, the hiree and
the hirer. The hiree may be a manufacturer, or a finance company. The
manufacturer sells asset to the hiree who sells it to the hirer in exchange for the
payment to be made over a specified period of time.
The hire purchase financing have three distinctive features:
1) The owner of the asset (hiree or manufacturer) gives the possession of the
asset to the hirer on agreement.
2) The ownership will transfer to the hirer on the payment of all instalments.
3) The hirer will have the option to terminate the agreement before the
transfer of ownership of the asset.
In the case of hire purchaser, hirer is entitled to claim depreciation, while in case
of lease, lessee is not entitled to claim depreciation. Hirer can charge only interest
portion of HP payments as expenses for tax computation, while in case of lease
financing, lessee can charge the entire lease payments as expenses for tax
computation. On payment of all instalments as agreed, the hirer become owner of
the asset and can claim its salvage value. Lessee does not become the owner of
the asset. Therefore, he has no claim over the asset’s salvage value. In case of
lease, the asset reverts back to the lessor at the end of lease period.