Lease Financing

Lease Defined:

• Lease is a contract between a lessor, the owner

of the asset, and a lessee, the user of the asset.
• Under the contract, the owner gives the right to
use the asset to the user over an agreed period
of time for a consideration called the lease
rental.
• As the legal owner, it is the lessor not lessee,
who is entitled to claim depreciation on the
leased asset.
 Type of Leases:

• Two types of leases can be distinguished:

• Operating Lease; and
• Financial Lease.

• Sale-and-lease-back is a special financial lease

arrangement.
 Operating Lease:

• Short-term, cancelable lease agreements

are called operating leases.
• Examples are: a tourist renting a car,
lease contracts for computers, office
equipment, car, trucks and hotel rooms.
• The lessor is generally responsible for
maintenance and insurance.
 Financial Lease:

• Long-term, non-cancellable lease

contracts are known as financial leases.
• Examples are plant, machinery, land,
building, ships, and aircrafts.
 Sale-and-lease-back:
• Sometimes, a user may sell an (existing)
asset owned by him to the lessor (leasing
company) and lease it back from him.
• Such sale-and-lease-back arrangements
may provide substantial tax benefits.
Cash Flow Consequences of a Financial
Lease:
• Suppose a company has found it financially
worthwhile to acquire an equipment costing
Rs.8 crore.
• The equipment is estimated to last eight
years.
• Instead of buying, the company can lease
the equipment for eight years at an annual
lease rental of Rs.1.6 crore from its
manufacturer.
• The company will have to provide for the
maintenance, insurance, and other
operating expenses associated with the
use of the asset in both alternatives –
leasing or buying.
• Assume a written-down depreciation of 25
percent per annum, a borrowing rate of 14
per cent, and a marginal tax rate of 35
percent for the company.
The cash flow consequences of
the lease would be:
• Avoidance of the Purchase Price
• Loss of Depreciation Tax Shield
• After-tax Payment of Lease Rentals
Cash Flow Consequences of a Lease
(Rs in lakh)
Year Price Depreciati Depreciati Before- After-Tax Net Cash
Avoided on Lost on Tax Tax Lease Lease
Shield Rental Rental Flow

Lost
(1) (2) (3) (4) = (3) x (5) (6) = (7) =
(5)x(1–
0.35 (2+4+6)
0.35)
0 800 800.00
1 -200.00 -70.00 -160.00 -104.00 -174.00
2 -150.00 -52.50 -160.00 -104.00 -156.50
3 -112.50 -39.38 -160.00 -104.00 -143.38
4 -84.38 -29.53 -160.00 -104.00 -133.53
5 -63.28 -22.15 -160.00 -104.00 -126.15
6 -47.46 -16.61 -160.00 -104.00 -120.61
7 -35.60 -12.46 -160.00 -104.00 -116.46
8 -26.70 -.934 -160.00 -104.00 -113.34
 Depreciation Shield and Cash Flows Under A
Lease (Rs. Lakh)
Year Asset Depreciati After-Tax Net Cash Present Present
Price on Tax Lease Flows Value
Avoided Shield Rental Factor at Value
Lost (ATLR) (NCF)
(P0) 9.1%
(TDEP)
(1) (2) (3) (4) (5=2+3+4) (6) (7=5 x 6)

0 800.00 800.00 1.0000 800.00

1 -70.00 -104.00 -174.00 0.9166 -159.49
2 -52.50 -104.00 -156.50 0.8401 -131.48
3 -39.38 -104.00 -143.38 0.7701 -110.42
4 -29.53 -104.00 -133.53 0.7058 -94.25
5 -22.15 -104.00 -126.15 0.6470 -81.62
6 -16.61 -104.00 -120.61 0.5930 -71.52
7 -12.46 -104.00 -116.46 0.5435 -63.30
8 -9.34 -104.00 -113.34 0.4982 -56.47

PV@9.1% -195.04 -573.49 +31.47 +31.47

 Summary of present values shown in the
above Table is as follows (Rs in lakh):
Purchase Price +800.00
Depreciation Tax Shield -195.04

After Tax Lease -573.49

Payments
Net Advantage of +31.47
Leasing
 Evaluating a Financial Lease:

• Leasing is a two-step decision for the

lessee firm.
• First, evaluate the economic viability of the
asset as an investment.
• If the asset has a positive NPV, acquire
the asset.
• Compare the costs of financing the asset
through leasing with that of normal
sources of financing.
 Net Present Value and Net Advantage of Leasing:

Situation Net Present Value Net Advantage Decision

of Investment of Leasing
1 Positive Positive Lease

2 Positive Negative Buy

3 Negative Negative Reject

4 Negative Positive Lease, if sum of net

present value and
net advantage of
leasing is positive,
otherwise reject.
Can a Lease Benefit Both Lessor and Lessee?

• A lease will be taken when it benefits both the

lessor and the lessee. It can benefit both when
their tax rates differ.
• Suppose the lessor has a tax rate of 35%; then,
he can take full advantage of tax shields. The
present value of the lease cash flows to the
lessor is given in the following table.
 Present Value of Lessor’s Cash Flows

Cash Flows Present value

Purchase Price -800.00

Depreciation Tax Shield +195.04

After-Tax Lease Payment +3.5843 Lt

(0.65 Lt x 5.5143)*
• * After-Tax Lease Payment (1 – 0.35)Lt ; 5.5143 is the
present value factor of an annuity for 8 years at 9.1
percent.

• The minimum lease payments for the lessor to

breakeven would be:
• Net Present Value = -800.00 + 195.04 + 3.5843 Lt
• 3.5843 Lt = 604.96 (since at break-even NPV = 0)
• Lt = 604.96/3.5843 = Rs.168.78 Lakh
Let the tax rate of the lessee be 0. The present
value to the lessee of the lease is given in the
following Table.

Cash Flows Present Value (Rs.

Lakh)

Purchase Price Avoided +800.00

Lease Payments* -4.6389 Lt
• * The 4.6389 is present value annuity factor for 8 years
at 14%.
• The break-even lease payments to the lessee would
be as follows:
• Net Advantage of Leasing = 800.00 – 4.6389 Lt = 0
• Lt = 800/4.6389 = Rs.172.46 Lakh
• The break-even levels of lease payments
of the lessor and the lessee give them
adequate room for negotiations. Note that
the break-even lease payments for both
lessor and lessee would be the same if
their tax rates are the same.
• If the actual lease payment = Rs.1.7 crore,
• The lessor’s gain is Rs.170 – 168.78 = Rs.1.22 lakh per
annum, and
• the lessee’s gain is Rs.172.46 – 170 = Rs.2.46 lakh per
annum.
• The PV of the lessor’s gain (at 9.1% discount rate)
• = (1 – 0.35) 1.22 x 5.5143 = Rs.4.37 lakh.
• The PV of the lessee’s gain (at 14% discount
rate)=Rs.2.46 x 4.6389 = Rs.11.41 lakh.
• Under a full-service lease, the lessor may bear
the maintenance, insurance and operating
costs. If so, the present value of the lease to
the lessee will increase by the present value of
the stream of after-tax operating costs.
• On salvage value, the value of the lease to the
lessee will decline by PV of after tax proceeds
from the sale of assets at the end of its
economic life.
• Net Advantage of a Lease (NAL) Including Operating Costs
and Salvage Value:
• The following equation can be used to find out NAL:

n
(1  T ) Lt  TDEPt
NAL  A0   t
(2)
t 1 [1  i (1  T )]

• Where A0 is purchase price of the asset, T is the tax rate of the

company, Lt is the lease rental paid in year t, TDEPt is the
depreciation tax shield in year t and i is the interest rate on
borrowings.
• We can modify Equation (2) as follows to calculate the net advantage
of leasing:

n
(1  T ) Lt  TDEPt n (1  T )OCt SVn
NAL  A0   t
 t
 n
(3)
t 1 [1  i (1  T )] t 1 (1  k ) (1  k )

• Where k is the after-tax cost of capital of the firm, OCt is the operating
cost in year t and SVn is the after tax salvage value of the leased
asset at the end of the life, n.
• In the example used so far, suppose the
equipment manufacturer agrees to maintain
the asset and that it would have cost the
lessee firm Rs.0.60 lakh per annum.
• Also, let the estimated after tax salvage
value of the equipment be Rs.18 lakh.
Assume a 14% after-tax cost of capital for
the lessee firm.
• The present value (PV) of the lease will increase by:
•
8
(1  0.35)0.60t
PV of After  tax Operating Cost    0.39 x 4.6389  Rs.1.81lakh
t 1 (1.14)t

• And decrease by
• PV of after tax Salvage Value = 18/(1.14)8 = 18 x 0.3506 = Rs.6.31
lakh.

• Thus, the net advantage of the lease will be:

• NAL = +31.45 + 1.81 – 6.31 = Rs.26.97
 In the following table the entire cash flows of the lease are given.
Year Asset Price Dep. Tax After-tax After-tax Salvage Net Cash
Avoided Shield Lost Lease Operating Value Flows
Rental cash Flows

(1) (2) (3) (4) (5) (6) (7=2+3+4+5

+6)
0 800.00 800.00
1 -70.00 -104.00 0.39 -173.61
2 -52.5 -104.00 0.39 -156.11
3 -39.38 -104.00 0.39 -142.99
4 -29.53 -104.00 0.39 -133.14
5 -22.15 -104.00 0.39 -125.76
6 -16.61 -104.00 0.39 -120.22
7 -12.46 -104.00 0.39 -116.07
8 -9.34 -104.00 0.39 -18.00 -130.95
PV 800.00 -195.04 -573.49 1.81 -6.31 26.97
(discounted (discounte
at 14%) d at 14%)
• The present values of the different flows can be
calculated by discounting each flow by a rate that
reflects its risk.
• The after tax lease rental and lost DTS are safe cash
flows since they are fixed and known. Hence, lease
being equivalent to a loan, the after tax lease rental
and lost DTS can be discounted by the after-tax cost
of borrowing, i.e., kd(1-t).
• Both operating costs and salvage value are difficult
to predict. Therefore, they should be discounted at a
rate higher than the firm’s borrowing rate. There is a
fair degree of unanimity among academicians about
using the firm’s cost of capital for discounting
operating costs and salvage value.