R.

Kannan
1
LEASING
MODULE - 6
R.Kannan
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Leasing
Operating lease:
The lessor maintains equipment
The lease period is shorter than economic life
The asset is returned to lessor at the end of lease period
Financial lease:
The lessor is usually only a financier
Leasee maintains equipment
The primary period covers assets useful life. Further lease at
a nominal price or asset is sold and proceeds split between
the lessor and lessee
First decide whether NPV is positive by discounting
by cost of capital
Then discount alternate financing cash flows by
discounting at cost of borrowing
R.Kannan
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Leasing
Lease or buy
Select the alternative with the highest NPV
t=n

A) Purchase option (NPV) = - A + X
t
(I-T) + D
t
T + S
n


t=1
(1+K)
t
(1+K)
n

A = Acquisition cost of asset
X
t
= Profit before depreciation, interest and tax
D
t
= Depreciation (WDV)
S
n
= Post-tax salvage value
n = Investment horizon
T = Corporate tax rate
K = Cost of capital
t=n n

B) Leasing (NPV) = X
t
(I-T) + L
t
T - L
t


t=1
(1+K)
t t=1
(1+K)
t
X
t
= Profit before depreciation and tax
L
t
== Lease rental due at the end of year t
R.Kannan
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Example
a) - Cost of equipment Rs.40 lakhs
- Loan Rs.20 lakhs, interest 14%, repayable in 5 annual equal instalments
- Revenues Rs.30 lakhs, costs other than interest and depreciation Rs.8 lakhs
- Debt to equity ratio 1:1, cost of equity 20%, cost of debt 10%
- Tax rate 30%
- Economic life 8 years, depreciation rate 33.33%
- Investment horizon 5 years; salvage value Rs.4 lakhs
- Primary lease period Rs.70.50 / Rs.1000 / quarter 5 years
- Secondary lease period Rs.3 / Rs.1000 / quarter
- Lease rentals payable in advance
- Lease rentals and purchase price of equipment includes all taxes
Advise the lessee whether to take on lease or buy

b) If the lessor has debt to equity ratio of 4:1 with cost of equity of 20% and cost
of debt at 10%, should he take this business
R.Kannan
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Cost of capital = 20 x 0.2 + 20 x 0.1 = 0.15
40

Purchase option

Years 0 1 2 3 4 5
A. Investment (40) -- -- -- -- --
B. Revenues -- 30 30 30 30 30
C. Costs -- (8) (8) (8) (8) (8)
D. Depreciation -- (13.33) (8.89) (5.93) (3.95) (2.63)
E. Profit before interest
and tax -- 8.67 13.11 16.07 18.05 19.37
F. Profit after tax
(tax at 33%) -- 5.77 8.73 10.70 12.02 12.90
G. Net salvage value -- -- -- -- -- 4.00
--------------------------------------------------------------------------
Net cash flow (F + D) (40) 19.10 17.62 16.63 15.97 19.53

Discount factor 15% (40) 0.87 0.756 0.658 0.572 0.497
(40) 16.62 13.32 10.94 9.13 9.71
= 19.72
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Lease option

Quarterly lease rentals Rs.2.82 lakhs

Cost of lease rentals

Annual cost 15% = quarterly cost of 3.55%

Present value annuity factor = 14.67

Present vale of cash outflows of leasing = Rs.41.37 lakhs

R.Kannan
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Cash flows associated with leasing

Years 1 2 3 4 5
Revenues 30 30 30 30 30
Costs other than lease
rentals 8 8 8 8 8
Profit before lease rentals
and tax 22 22 22 22 22
Tax 7.26 7.26 7.26 7.26 7.26
Profit after tax 14.74 14.74 14.74 14.74 14.74
Tax shield on lease rentals
(2.82 X 4 X 0.33) 3.72 3.72 3.72 3.72 3.72
Net cash flow 18.46 18.46 18.46 18.46 18.46
Present value of cash flows = 3.353 X 18.46 = Rs.61.57 lakhs
NPV = (61.57 41.37) = Rs.20.2 lakhs
Since NPV in lease is marginally better, lease option is preferable.
R.Kannan
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Lessors view

Present value of lease rentals

Annual return of 12% = 2.9% quarterly

Net present value of lease rentals = Rs.42.32 lakhs

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b) Present value of cash flows (other than lease rentals)

Years 1 2 3 4 5
Depreciation 13.33 8.89 5.93 3.95 2.63
------------------------------------------------------------
A. Tax shield on
depreciation 4.40 2.93 1.95 1.30 0.87

B. Tax on lease rentals (3.72) (3.72) (3.72) (3.72) (3.72)

Net cash flow (A-B) 0.68 (0.79) (1.77) (2.42) (2.85)

Discounting at 12% 0.893 0.797 0.712 0.636 0.567

Net present value at 12% discount (Rs.4.44 lakhs)

Net present value of flows = Rs.42.32 4.44
= Rs.37.88 lakhs
Investment = Rs.40 lakhs
Hence lessor should not enter into this transaction
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Other factors to be considered in leasing or purchasing

a) Technology obselence
b) Problems of maintenance
c) Tax systems
d) Access to various methods of financing