Question

A). Critically analyse the types of leases and discuss the various steps required in the calculation of leases give appropriate examples. 5 pages

Answer 1

• Leasing is a contract where one party (Lessor / Owner / Leasing company) pirchases the assets and permits its use by another party (Lessee) over a specified period of time. It is an alternative to the purchase of an asset out of own/borrowed funds.
• Leasing is the renting out of an asset by the Owner to a person for a recurring consideration (Lease Rentals) payable over the period of tenancy.

Types of Lease :

PARTICULARS	FINANCIAL LEASE/ CAPITAL LEASE	OPERATING LEASE
1. MEANING	Arrangement to finance the use of equipment for a major part of its useful life. It is a loan in disguise	Does not secure for the Lessor the recovery of capital outlay plus a return on the funds invested , during the lease term.
2.TERM	Longer Term	Shorter Term
3.RISK AND REWARDS	Passed on to the Lessee. The Lessor remains the legal owner only.	Lessee is only provided the use of asset for a fixed time. Risk incident to ownership is wholly to the Lessor.
4. OBSOLESCENCE RISK	Borne by Lessee	Borne by Lessor
5. RIGHT TO CANCEL	Generally Non Cancellable by either parties	Kept Cancellable by Lessor as other potential Lessees are available
6. COST OF REPAIRS	Lessor as financier does not bear any cost of repairs.	Not borne by Lessor
7. PAY OUT	Repays cost of asset and interest thereon. FULL PAY OUT.	NON PAYOUT as Lessor intends to lease the same asset over and over again

LEVERAGED LEASE : the lessor borrows a substantial portion of the asset purchase price from a lender (Commercial bank) with full recourse to the Lessee without recourse to the lessor.

ADVANTAGES OF A LEASE :

TO THE LESSOR

1. FULL SECURITY : Can take repossession of asset at any time , if Lessee defaults.
2. TAX BENEFITS : By way of depreciation as leased assets carry higher Depreciation rates.
3. HIGH PROFITS : Due to higheer Dep Rates -> Quicker Capital Recovery + Higher Profitability as Rate of Return is greater thant that in Lending Business
4. TRADING ON EQUITY : Lessors have low equities + Higher Borrowed funds -> HIgher Financial Leverage -> ROE very high

TO THE LESSEE

1. 100% FINANCING AVAILABLE WITHOUT ANY DOWN PAYMENT
2. NO DILUTION OF OWNERSHIP
3. LESS RISK : Risks rest completely with Lessor esp in Operating Leases. Lessee can opt for newer technologies in assets by choosing different Lessor.
4. SALE AND LEASEBACK may help in overcoming financial emergencies
5. ENHANCED OPERATIONAL INDEPENDENCY
6. TAX BENEFITS : cost of lease is held as expenditure -> cost of asset amortized rapidly -> huge tax saving.
7. SUITABLE FOR SMALLER ASSETS AS THEIR RENTALS ARE IMPRACTICABLE'
8. ELIGIBILITY TO BORROW : Lease Payments are not required from credit and can be paid from the income during the operating period. This neither affects Debt to Equity Ratio nor the Current Ratio of the Lessee.

Methods for evaluation of Leasing Proposals

1. Present Value Analysis Method:

• Compute PV of lease payments adjusted for tax savings.[ Note: Discount rate= Post tax cost of debt]
• Compute PV of Cash flows under Debt Financing, i.e Annual Loan Repayments adjusted for tax savings on depreciation and interest expense.
• Leasing is preferred , if PV of outlows under lease option is lower.

2. IRR Method:

• This method seeks to find the IRR instead of calculating NPV of Cash Outflows for two financing alternatives.
• IRR method aims to compute the rate at which the Lease rentals, Net of tax shield on depreciation are equal to Cost of Leasing.
• The rate arrived is called IRR and is equal to the Cost of Leasing and this rate can be compared with that of the available source of finance.
• Every Lessor imputes a financial cost or change or interest rate into the calculation of Lease rentals. IRR method attempts to find this rate.
• This may be determined either with reference to Annuity/Present value tables or by the use of mathematical model for determining Compund Interest Rate.

3. Bower- Herringer- Williamson Method:Payment streams are divided into two parts-(i) Cash flows associated with financing (ii) Cash flows associated with Tax Savings

• Financing Aspect- Financial Advantage or Disadvantage=PV of Debt(-) Pv of lease payments(Gross), the rate of discount being the Gross Cost of Debt Capital.
• Tax Aspect- Operating Advantage or Disadvantage= Comparative Tax benefit between Debt and Leasing alternatives, discounted at an appropriate cost of capital.
• Net Effect- If the Net effect of the above 2 aspects is an advantage then Leasing is preferable.

EXAMPLE OF A LEASE PAYMENT CALCULATION WITH STEPS