Leasing | Lease | Net Present Value

LEASE FINANCING

Meaning
A lease is a contract whereby the owner of an asset (the lessor) grants to another person (the lessee) exclusive right to use the asset for an agreed period of time, in return for the payment of a rent (called lease rental)
Asset
Lessor (owner of the asset) Lessee (user of the asset)

Rentals

Examples
Capital assets like land, buildings, equipments, machinery, vehicles are the usual assets which are generally acquired on lease basis. The lessor remains the owner of the asset, but the possession and economic use of the asset is vested in the lessee.

Leasing as a source of Finance Leasing companies finance for: ‡ Modernization of business ‡ Balancing equipment ‡ Items entitled to 100% or 50% depreciation ‡ Assets which are not being financed by banks/institutions ‡ Vehicles and other durables .

taxes and insurance and other expenses ‡ Lessor contacts manufacturer. ‡ Agreement between lessee and lessor.Steps in leasing Transaction ‡ Select asset. supplier. etc. price. terms of delivery. design specifications. It contains following terms and conditions:  Lease period  Timing and amount of rental payments  Option to renew or purchase  Payment of cost of maintenance. makes payment after it has been accepted by lessee . repairs. warranties.

The essential features of a leasing A Valid Contract of Leasing: legal and written ‡ Delivery of Goods: goods are used in physical form ‡ Purpose: ‡ Consideration: ‡ Return of the Goods: due to obsolescence and misuse ‡ Ownership: remains with lessor ‡ Methodology: ‡ .

Types of Lease The lease agreement can be classified broadly into four categories: (i) Financial Lease (ii) Operating Lease (iii)Leverage Lease (iv)Sale and Lease Back .

At lease it must give an option to the lessee to purchase the asset he has used at the expiry of the lease.Financial Lease ‡ A financial Lease is also known as Capital Lease. . Net lease and close lease. The lease agreement is irrevocable. Long-term. Under this lease the lessor recovers 90% of the fair value of the asset as lease rentals and the lease period is 75% of the economic life of the asset. non-cancellable lease contracts are known as financial leases. ‡ In FL lessor agrees to transfer the title for the asset at the end of the lease period at a nominal cost.

Example: maintenance. technical advice. Such lease is also called service lease. . but also undertakes to provide services attached to such assets. Computers. repairs. automobiles and trucks are the typical capital assets which are leased under operating lease arrangement. the lessor not only leases the asset of which he remains the owner throughout.Operating Lease In case of operating lease. office equipments. etc.

leased again to another lessee for another lease period. The leased asset is returned back to the lessor at the end of the lease period and is. .Features of an operating lease are as follows : ‡ The lease contract is generally for a period which is considerably shorter than the useful life of the leased asset. recover the full cost of the asset from one lessee only. ‡ The lessor does not. thereafter. therefore.

‡ Operating lease generally contains a cancellation clause also. Such clause is beneficial to the lessee as he may terminate the lease. ‡ The lease agreement contains a maintenance clause whereby the lessor is required to maintain the leased assets. wherein the lessee retains the right to cancel the lease any time before the lease period is over. if the asset becomes obsolete or his need for the asset is over. ‡ The lease rental includes: (a) a part of the cost of the equipment (b) cost of the maintenance services provided (c) profit of the lessor .

‡ Leveraged lease is just opposite to the above.Leveraged Lease ‡ In case of an ordinary lease. the creditor remains entitled to have recourse to the lessee. the creditor cannot claim the same from the lessee.. The lease rental is assigned to the creditor. the lessor purchases the asset with an appropriate mix of debt and equity. The lessee is required to pay the lease rental directly to creditor . In case the lessor defaults in making repayment of the debt. he can recover his claims from the lessee also. In such case. He will have recourse to the lessor only. i.e.

sells the same to the lessor. This is called 'Sale and Lease Back arrangement'. Thereafter. . and thereafter takes the same asset from him on lease basis. the lessee immediately recovers the value of his already owned assets from the lessor. Under this arrangement. the lessee makes payment of the lease rentals periodically as usual.Sale and Lease Back Type of lease arrangement wherein the lessee who already owns the assets.

which can be utilized otherwise to meet his working capital requirements or to purchase another asset on cash payment basis.Such a lease arrangement enhances the liquid resources of the lessee immediately. .

be returned or otherwise disposed of according to the directions of the person delivering them." The person delivering the goods is called the bailor and the person to whom they are delivered is called the bailee` . upon a contract that they shall. when the purpose is accomplished.LEGAL ASPECTS OF LEASING According to Section 146 of the Indian Contract Act. 1872 Bailment is "the delivery of goods by one person to another person for some purpose.

these may be stated as follows : (1) The lessor has the duty to deliver the asset to the lessee. the obligations of the lessor and the lessee are similar to those of the bailor and the bailee (unless expressly specified otherwise in the lease agreement) as given in the Indian Contract Act. to legally authorize the lessee to use the asset and to leave the asset in peaceful possession of the lessee during the lease period. to protect the lessor's title. to take reasonable care of the asset. .Since an equipment lease transaction falls in the category of a bailment contract. (2) The lessee has the obligation to pay the lease rentals as specified in the lease agreement. Briefly.

size.e.. (3) Duration of Lease Period : This clause specifies the period for which the asset is leased. (2) Description of the Asset : This clause gives the description of the equipment to be leased. specification etc. which is called the primary period.MAIN CLAUSES IN THE LEASE AGREEMENT (1) Nature of the Lease : This clause specifies the nature of the lease (i. model. operating lease. The clause generally also gives an option to the lessee to renew the agreement for a further period. financial lease or a leveraged lease) and the names of the parties to the Agreement. (4) Lease Rentals . its make.

(9) Right to Inspect Equipment : This clause gives the lessor the right to enter the premises of the lessee and to inspect the equipment as and when he desires. . The cost of such maintenance shall be borne by the lessee. (6) Right to Use : (7) Repairs and Maintenance : Usually this clause states that the lessee shall maintain and repair the equipment and keep it in good and working condition.(5) Delivery and Re-delivery : This clause mentions when and how the leased equipment would be delivered to the lessee and how it will be delivered back to the lessor on the completion of the lease period. (8) Alterations/Additions to Equipment : This clause states that the lessee shall not make any alterations or additions to the equipment or remove it from the premises without the written consent of the lessor.

(13) Other Charges : This clause shall specify which party will pay the various expenses and charges in connection with the purchase and installation of equipment. losses. Lessee shall pay the premium and renew the policy every year. (11) Prohibition of Sub-leasing : This clause prohibits the lessee from sub-leasing the equipment or selling it to any party.(10) Damage to Equipment : It is usual to stipulate that the lessee will bear all risks. . theft or destruction of the equipment as long as it is in his custody. damages. (12) Insurance : This clause requires the lessee to take out a fire insurance policy in respect of the equipment in the joint names of the lessee and the lessor (named therein as the owner).

(14) Default by Lessee and Remedies : It is usual to include a clause indicating the specific events of default by the assesse and the remedies available to the lessor in such cases. . and (c) to seize the equipment given on lease. The remedies may be : (a) to declare that all unpaid rentals are due and payable immediately and to sue the lessee for the recovery of the same. (b) to terminate the lease agreement.

ACCOUNTING TREATMENT OF LEASE (Lessor) 1. The leased asset is shown on the balance sheet of the lessor. The entire lease rental is treated as income in the books of the lessor 4. Lease rentals are shown on actual basis not on accrual basis . 2. Depreciation and other tax shields associated with the leased asset are claimed by the lessor 3.

The lease rentals should be shown on accruals basis and adjustments for outstanding and prepaid should be done 4. The assets taken under lease may be shown as a footnote in balance sheet 2. Disclose future obligations of the lease by way of footnote .ACCOUNTING TREATMENT OF LEASE (Lessee) 1. Lease rentals should be charged to the income statement 3.

2. The lessee can claim lease rentals as tax-deductible expenses. The lessor can claim investment allowance (this may be doubtful) and deprecation on the investment made in leased assets. The lease rentals received by the lessor are taxable under the head of 'Profits and Gains of Business or Profession'. .Tax Implication on lessor and lessee 1. 3.

In this way the saving in capital or financial resources can be used for other productive purposes e. (c) No Risk of Technological Obsolescence (d) Improvement in Liquidity : Leasing enables the lessee to improve their liquidity position by adopting the sale and lease back technique. (b) Saving of Capital : Leasing covers the full cost of the equipment used in the business by providing 100% finance.Advantages of Leasing (a) Convenience in case of short-term need : need is over. purchase of inventories.g. The lessee is not to provide or pay any margin money as there is no down payment. .

machines or vehicles only. They can easily bargain with the suppliers/manufacturers etc. who is well equipped. qualified and experienced to provide such services efficiently. and acquire the assets at better prices and can economise in other administrative expenses also. (g) Benefit of Tax Shield . (f) Administrative ease: Many leasing companies specialise in leasing a few types of equipments. the lessee avails of the maintenance and other services provided by the lessor. It is a revenue item do not need elaborate justifications.(e) Efficient Maintenance Services : Under operating or full service lease. the lessee pays for such services in the form of higher rentals. Of course.

management attention and follow up but leasing is time saving (i) Lessor risk for lessor: ownership with lessor so in case of any default recover the asset (j) Flexibility: tailor made to the lessess needs (k) Good for small firms: . speed and convenience: borrowing involves scrutiny by lenders. documentation.(h) Transaction cost. long time in processing.

Limitations ‡ Not suitable for project finance ‡ Certain tax benefits/incentives such as subsidy may not be available ‡ Cost of financing higher than that of debt financing ‡ It is irrevocable ‡ If lessee is not able to pay rentals regularly. the lessor would suffer a loss .

Hence lessee is not protected in case of any breach of warranties related to assets .Limitations ‡ If contract is to be discontinued then heavy penalty is paid but if it is own asset can be sold ‡ In lease agreement lessor purchases asset not the lessee.

Evaluation of Leasing(Lessee point of view) ‡ Decision about investment in asset ‡ Comparison of cost of leasing and cost of financing ‡ Payment of lease rental is similar to interest borrowings .

Steps ‡ Calculate present value of net cash flow of buying option NPV (B) ‡ Calculate present value of net cash flow of leasing option NPV (L) ‡ Decide buy or lease on the basis of following criterion: (i) NPV (B) is + and greater than NPV (L) purchase asset (ii) NPV (L) is + and greater than NPV (B) lease the asset (iii) NPV (B) and (L) are both negative reject proposal .

Evaluation of Leasing(Lessor point of view) Capital budgeting methods can be applied ‡ Present value method: (i) Determine cash outflows (ii) Determine cash inflows (iii)Calculate present value by applying discount rate (iv)If PV of cash inflow is more than PV of cash outflow asset can be given on lease .

Internal Rate of Return Method (i) Determine future cash inflows for the period of the lease (ii) Determine rate of discount .

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