Ch_22 Lease & Hire Purchase

8/13/2019 Ch_22 Lease & Hire Purchase

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ASSET-BASED : LEASE, HIRE PURCHASEAND PROJECT FINANCING

CHAPTE

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LEARNING OBJECTIVES

Define lease and highlight its true advantages

Explain the methods for evaluating a lease

Discuss the concept of a leveraged lease

Highlight the difference between hire purchase

financing and lease financing

Focus on project financing as a special mechanism

for financing large projects

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Lease Defined

Lease is a contract under which a lessor, the owner of theassets, gives right to use the asset to a lessee, the user ofthe assets, for an agreed period of time for a considerationcalled the lease rentals.

In up-fronted leases, more rentals are charged in the initialyears and less in the later years of the contract. Theopposite happens in back ended leases.

Primary leaseprovides for the recovery of the cost of the

assets and profit through lease rentals during a period ofabout 4 or 5 years. It may be followed by a perpetual,secondary lease on nominal lease rentals.

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Types of Leases

1. Operating Lease

2. Financial Lease

3. Sale-and-lease-back

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Operating Lease

Short-term, cancelable lease agreements are calledoperating lease.

Tourist renting a car, lease contracts for computers,

office equipments and hotel rooms.The Lessor is generally responsible for maintenance

and insurance.

Risk of obsolescence remains with the lessor.

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Financial Lease

Long-term, non-cancelable lease contracts are known

as financial lease.

Examples are plant, machinery, land, building, ships

and aircrafts.

Amortise the cost of the asset over the terms of the

leaseCapital or Full pay-out leases.

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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.

In April 1989, Shipping Credit and Investment Corporation of

India purchased Great Eastern Shipping Company bulk

carrier, Jag Lata, for Rs 12.5 Cr and then leased it back to

GESC on a 5 years lease, the rentals being Rs 28.13 Lakh per

month. The ships WDV was Rs 2.5 Cr.

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Cash Flow Consequences of a

Financial Lease

Avoidance of the purchase price

Loss of depreciation tax shield

Aftertax payments of lease rentals

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Commonly Used Lease

Terminology

1. Leveraged Lease

2. Cross-border lease

3. Closed and open ended lease

4. Direct lease

5. Master lease

6. Percentage lease

7. Wet and dry lease8. Net net net lease

9. Update lease

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Myths about Leasing

Leasing Provides 100% Financing

Leasing Provides Off-the-Balance-Sheet Financing

Leasing Improves Performance

Leasing Avoids Control of Capital Spending

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Advantages of Leasing

1. Convenience and Flexibility

2. Shifting of Risk of Obsolescence

3. Maintenance and Specialized Services

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Evaluating a Lease

Equivalent Loan Method

Net Advantage of a Lease Method

IRR Approach

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Equivalent Loan Method

EL is that amount of loanwhich commits a firm toexactly the same streamof fixed obligations asdoes the lease liability.

Method1. Find out incremental cash

flows from leasing.

2. Determine the amount ofequivalent loan such cash

flow can service.3. Compare the equivalent

loan so found with leasefinance.

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N t P t V l d N t


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Net Present Value and Net

Advantage of Leasing

The direct cash flow consequences are:

1. The purchase price of the asset is avoided.

2. The depreciation tax shield Is lost.

3. The after tax lease rentals are paid.

The net present value of these cash flows at

after tax cost of debt should be calculated. If it

is positive, lease is beneficial.

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Investment and Net Advantage of

Leasing

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L B fit t L d


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Lease Benefits to Lessor and

Lessee

A lease can benefit both when their tax ratediffers.

Leasing pays if the lesseesmarginal tax rate isless than that of the lessor. In fact in a lease, thelessee sells his depreciation tax shield to thelessor.

In the absence of taxes it is hard to believe thatleasing would be advantageous if the capital

markets are reasonably well functioning.Gain of both is loss to the government in form of

taxes.

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Leasing Benefits Come

fromBoth, lessor and lessee, gain at governmentsexpense

because of the difference in their tax rates.

The government gains from the tax on lease rentals

while it loses on depreciation and interest tax shields.The implicit principal payments in a lease rental are

shielded by depreciation, while interest deductions

provide for implicit return on the lesseescapital.

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(NAL) i l di


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(NAL) including

Operating Costs and Salvage

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Internal Rate of Return

Approach

IRR of a lease is that rate which makes NALequal to zero.

1. Ao = Purchase Price.

2. L= Lease Rentals.

3. DEP= Depreciation

4. T = Tax Rate

5. OC = Operating Cost

6. SV = Salvage Value

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1

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1 1

nn

ot n

tt

t

T L OC TDEP SVA

r r

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AND

SALVAGE VALUE UNDER

INDIAN TAX LAWSOnce the firm sells an asset, it will know thesalvage value on which it will lose the depreciation

tax shield.

Thus, the lost depreciation tax shield on salvagevalue should be treated as safe cash flows and it

would be discounted at the after-tax cost of

borrowing.

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LEVERAGED LEASE21


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Hire PurchaseConditions

The owner of the asset (the Hirer or the manufacturer) gives thepossession of the asset to the Hirer with an understanding thatthe Hirer will pay agreed instalments over a specified period oftime.

The ownership of the asset will transfer to the hirer on thepayment of all instalments.

The Hirer will have the option of terminating the agreement anytime before the transfer of ownership of assets. ( CancellableLease)

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Hire purchase financing

Diff b t L i d


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Difference between Leasing and

Hire Purchase Financing

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Instalment Sale

Instalment Sale is a credit sale and the legal

ownership of the asset passes immediately to the

buyer as soon as the agreement is made between

the buyer and the seller.Except for the timing of the transfer of

ownership, instalment sale and hire purchase are

similar in nature.

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Evaluation of Hire Purchase

FinancingThe hiree charges interest at a flat rate, and he

requires the hirer to pay equal instalments at each

period.

The sum-of-years-digit (SYD)method is the mostcommonly used methods for calculating interest

over a period of time.

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Project Financing

Scheme of financing a particular economic unit inwhich a lender is satisfied in looking at the cashflows and the earnings of that economic unit as a

source of funds, from which a loan can be repaidand to the assets of the economic unit as a collateralfor the loan.

It is different from the traditional form of financing,

i.e., the corporate financing or the balance sheetfinancing.

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B l h t fi i


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Balance sheet financing vs.

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Characteristics

1. Separate project entity

2. Leveraged financing

3. Cash flows separated

4. Collateral

5. Sponsors guarantees

6. Risk sharing

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P j t fi i ll


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Project financing allows

sponsors to:

Finance projects larger than what the companys

credit and financial capability would permit,

Insulate the companys balance sheet from the

impact of the project,

Use high degree of leverage to benefit the equity

owners.

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Financing Arrangements for


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Financing Arrangements forInfrastructure Projects

1. The Build Own Operate Transfer (BOOT)

Structure.

2. The Build Own Operate (BOO) Structure.

3. The Build Lease Transfer (BLT) Structure.

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BOOT/BOO Structu re of a Power Plant

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The Bu ilt-Lease-Trans fer (BLT) Struc ture


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Project Financing Risk and thei

Allocation

Risks1. Project Completion Risk

2. Market Risk

3. Foreign Currency Risk4. Inputs Supply Risk

Risk Mitigation1. By Government

1. Country Risk2. Sector Policy Risk

3. Commercial Risk

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Financial Structure of


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Financial Structure of

Infrastructure ProjectsDebt

Bonds

Equity

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and Financial Structure in

Infrastructure Project FinancingReturn on equity

Risk measurement

Impact of guarantees

Financial structure

Taxes

Financial distress

Government restrictions

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Documents

Ch_22 Lease & Hire Purchase