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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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C C f
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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
Value18
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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
10
1 1
nn
ot n
tt
t
T L OC TDEP SVA
r r
AND
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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.
Project financing27
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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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