Leasing1
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Leasing involves the periodic payment of rentals in exchange for the right to use an asset for a fixed period of time. There are advantages to both the lessor and lessee. For the lessor, it provides a stable business and opportunities to sell spare parts or the asset after the lease term. For the lessee, leasing allows for efficient use of funds without capital investment and a potentially cheaper source than outright purchase. Both parties must consider factors like taxes, costs of capital, and break-even rental rates to determine if a lease is financially advantageous.
Leasing1
- 1. LEASING An Overview
- 2. Characteristics Periodical payment of rentals Lessor Lessee Right to use an asset for a fixed period of time Ownership rests with the lessor
- 3. Term Lease Period = Lease agreement is operational Perpetual lease Primary Lease Period Secondary
- 4. Tests for Financial Lease Substance Test: Lessee Compliance with No.2 point Full Payment Test: Lessor Compliance with No.8 point – Transfer of Title Test: Lessee has an option to buy the asset Lease Term Test: Lease term extends to the asset’s life
- 5. Myths about Leasing Off-balance sheet financing No evaluation for capital expenditure – Cash flow consequences? Better Performance – Possible to enhance ROI, but the transaction should yield a positive NPV
- 6. Advantages of Leasing Advantages to the lessor: 1. Stable Business – Lessee’s continued patronage 2. Sale of spare parts 3. Second-hand market 4. Tax benefits 5. Fillip to capital market 6.Easy finance
- 7. Advantages of Leasing Advantages to the Lessee: 1. Efficient use of funds - No capital investment 2. Cheaper Source - than buying option 3. Enhanced borrowing capacity - Lower D/E Ratio 4. Off-balance sheet borrowing - - do - 5. Tax benefits 6. Guard against obsolescence - Lessee can terminate the lease at any time and take up another asset under fresh lease
- 8. Limitations Disguised form of debt financing Loss of depreciation tax shield, when depreciation rates are high and leasing is preferred over buying Possibility of double sales tax in certain states Unfavourable capital gearing for the lessee No ownership Default Risk Working Capital not considered Indiscriminate finance
- 9. Tax Aspects of Leasing Lessor: Deduction of depreciation from taxable income Income from lease rentals is taxable under “Profits and Gains of Business and Profession” Deductible expenses: Depreciation Rent, rates, taxes, repairs and insurance Amortization of preliminary expenses Interest on borrowed capital Bad debts All expenses incurred in furtherance of business Entertainment expenses (with a cap) Travel expenses (as per approved norms) (See Illustration No.3.5 M Y Khan)
- 10. Lessee: Allowability of lease rentals – allowed as normal business expenditure if they are not i. of capital nature, ii. Personal expense and relates only to the business purpose. Deductibility of Incidental Expenses – Repairs, Maintenance, Insurance, Finance Charges,…(Incidental) Installation expense (revenue expense in the year of incurrence)
- 11. Tax Planning Lessee: Flexible Restructuring of Lease Rentals – Substantial part of the lease rentals payable in the first year and a very small fraction during the remaining lease term Lower rentals in earlier years and higher in later years depending on cash flows Purely tax-driven structure of lease rentals not allowed by the IT authorities (See Illustration No.3.6 M Y Khan) Transfer of Investment-related Unabsorbed Tax Shield – Lessee firm enjoys 100% tax deduction (exports) – Tax shield on fresh capital investment would not have any impact on its cash flows – Tax shields can be transferred to the lessor who will consider lower lease rentals (See Illustration No.3.7 M Y Khan)
- 12. Funding Aspects of Leasing Deposits – Major source of finance Bank Borrowings – Maximum Limit – 10 times of NOF including deposits, borrowings from banks/FIs, debentures, bonds Maximum bank borrowings would be 3 times of NOF where 75% of the company’s assets are in equipment leasing and where 75% of its gross income is from leasing NOF = Paid up Capital + Free Reserves – Accumulated balance of loss, where Free Reserves represent share premium account, capital and debenture redemption reserves and any other reserve not created for payment of any future liability or for depreciation in assets or for bad debts or a reserve created by revaluation of assets RBI has freed the restrictions w.e.f.April 1997
- 13. Nature of Facility – based on the expected flow of lease rental receivables Maximum Permissible Bank Finance – Calculate outstanding credit for next five years Calculate relevant Drawing Power against that particular transaction Exclude – a. Funds raised from financial/inv. Institutions b. DPGs provided by banks, and c. Assets created against DPGs issued by banks This will imply bank finance will be to an extent of 2 – 3 times of NOF.
- 14. Requirements for Bank Finance Current Ratio – Minimum 1.33 Reports - (See page no. 203 Dr S Gurusamy)
- 15. Lessee’s Perspective of Leasing Lease rental payments are similar to payments of interest on debt Hence, alternative to borrowing Choice between debt financing versus lease financing Decision-criterion – Net Present Value of Leasing/Net Advantage of Leasing – NPV(L)/NAL Discount Rate used is the marginal cost of capital for all cash flows except lease payments and tax cost of debt for lease payments Value of interest tax shield is included as a foregone cash flow in the computation of NPV(L)/NAL
- 16. NPV(L)/NAL NPV(L)/NAL = Investment Cost - PV of lease payment (discounted by Kd) - PV of tax shield on lease payment (discounted by Kc) - Management Fee + PV of tax shield on management fee (disc.by Kc) - PV of Depreciation shield (discounted by Kc) - PV of Interest Shield (discounted by Kc) - PV of residual/salvage value (discounted by Kc) Where Kc = Post-tax marginal cost of capital, and Kd = Pre-tax cost of long-term debt
- 17. NPV(L)/NAL negative means leasing alternative should be used. NPV(L)/NAL positive means borrowing alternative would be preferable. Alternative approach is Determine the PVs of cash outflows after taxes under both the alternatives Select the alternative with the lower PV of cash outflows (See Illustration No.4.1 M Y Khan)
- 18. Break-Even Lease Rental (BELR) for lessee The point where the Net Advantage of Leasing (NAL) is zero. The rental at which the lessee is indifferent between lease financing and borrowing/buying. Maximum level of rental which the lessee is willing to pay If the BELR > the actual rental, the lease proposal would be acceptable. (See Illustration No. 4.4 M Y Khan)
- 19. Lessor’s Perspective of Leasing Whether to accept a lease proposal, or to choose from alternative proposals Determine break-even rental for the lessor, negotiation and fixation of lease rentals (See Illustration No.4.5 M Y Khan) • BELR for a lessor – minimum lease rental which he can accept • NAL/NPV(L) at this level of rental is zero. • Discount Rate to compute NAL is the marginal over-all cost of funds to the lessor (See Illustration No. 4.6 M Y Khan)