Chapter30 leasinghirepurchaseandprojfinance

Chapter 30

LEASING, HIRE PURCHASE, AND PROJECT FINANCE

Centre for Financial Management , Bangalore

OUTLINE

• Types of Leases

• Rationale for leasing

• Mechanics of leasing

• Operating Lease

• Financial lease in the Context of Capital Budgeting

• Leasing as a Financing Decision

• Hire Purchase Arrangement

• Choice between Leasing and Hire Purchase

• Project Finance Centre for Financial Management , Bangalore

TYPES OF LEASES

• A lease represents a contractual arrangement whereby the lessor grants the lessee the right to use an asset in return for periodical lease rental payments

• Leases may be classified as follows:

• Finance lease vs. operating lease

• Sale and lease back vs direct lease

• Single investor lease vs leveraged lease

• Domestic vs international lease


FINANCE LEASE

A finance lease, or capital lease, is essentially a form of borrowing. It salient features are:

• An intermediate term to long-term non-cancellable

arrangement.

• Fully amortised during the primary lease period.

• Lessee is responsible for maintenance, insurance, and

taxes.


OPERATING LEASE

An operating lease is a lease other than a finance lease. Its salient features are:

• The lease term is significantly less than the economic life

of the equipment

• The lessor usually provides the operating know-how and

insures and maintains the equipment


PLAUSIBLE REASONS FOR LEASING

• Convenience

• Benefits of standardisation

• Better utilisation of tax shields

• Fewer restrictive covenants

• Lower cost of obsolescence risk

• Expeditious implementation

• Matching of lease rentals to cash flow capabilities


DUBIOUS REASONS FOR LEASING

• Hundred percent financing

• Circumvention of certain controls

• Favourable Financial Ratios

• Favourable ratios


MECHANICS OF LEASING

• Legal aspects of leasing

• Typical contents of a lease agreement

• Sales tax provisions relating to leasing

• Procedural aspects of leasing

• Income tax provisions relating to leasing

• Accounting treatment of leases


LEGAL ASPECTS OF LEASING

As there is no separate statute for equipment leasing in India, the provisions relating to bailment in the Indian Contract Act govern equipment leasing agreements as well.

• In essence, it means the following:

• The lessor has the duty to deliver the asset to the lessee, to legally authorise the lessee to use the asset, and to leave the asset in peaceful possession of the lessee during the currency of the agreement

• The lessee has the obligation to pay the lease rentals as specified in the lease agreement, to protect the lessor’s title, to take reasonable care of the asset, and to return the leased asset on the expiry of the lease period.


INCOME TAX PROVISIONS RELATING TO LEASING

• Depreciation can be claimed by the lessor and not the lessee

• Lease rentals received by the lessor are taxable under the head of ‘Profits and Gains of Business or Profession’

• The lease rentals paid by the lessee are tax-deductible expenses for the lessee.

These provisions apply to operating as well as finance leases


ACCOUNTING TREATMENT OF LEASING

• Operating leases are capitalised in the books of the

lessor. Lease payments are treated as income of the

lessor and expense of the lessee.

• Finance leases must be capitalised in the books of the

lessee.


ACCOUNTING TREATMENT OF FINANCIAL LEASE

• In a finance lease, the leased equipment is shown as an asset on the balance sheet of the lessee. Its value is equated to the present value of the committed lease rentals. The leased asset is matched by a corresponding liability called the ‘lease payable’.

• Lease payments are split into two parts : finance charge is treated as an expense on the profit and loss account and the principal amount is deducted from the liability ‘lease payable’.

• The leased asset is ‘depreciated’ in the books of the lessee as per its depreciation policy.


OPERATING LEASE

Conceptually, the decision rule for choosing between

buying and leasing is fairly simple. Buy the asset if the

post-tax EAC (equivalent annual cost) of ownership is less

than the post-tax lease rental; lease the asset if the post-tax

EAC of ownership and operation is more than the post-tax

lease rental.


LEASING AS A FINANCING DECISION

In finance literature, a leasing decision is commonly

regarded as a financing decision. The decision to invest in

the asset is taken for granted and the option of leasing is

compared with the option of buying with borrowed funds.

Leasing is compared with borrowing because both of them

entail similar obligations.


CRITERIA FOR EVALUATING A

LEASE PROPOSAL

• Net present value

• Internal rate of return

• Equivalent loan amount


WHEN IS A FINANCIAL LEASE MUTUALLY BENEFICIAL

Other things being equal, the potential gains from leasing are more when:

• The tax rate of the lessor is much higher than the tax rate of the lessee.

• The depreciation charges are significantly higher in the initial years of the lease.

• The lease is structured in such a way that the lease payments are concentrated toward the end of the lease period.

• The interest rate is high. Centre for Financial Management , Bangalore

FEATURES OF A HIRE PURCHASE ARRANGEMENT

• The hiree purchases the asset and gives it on hire to the hirer.

• The hirer pays regular hire purchase instalments over a specified period of time. These cover interest as well as principal repayment.

• The hiree charges interest on a flat basis.

• The total interest collected by the hiree is allocated over various years using some method like the ‘sum of the years digits’ method.


CHOICE BETWEEN LEASING

AND HIRE-PURCHASE

1. Estimate the post-tax cash flows associated with these options.

2. Calculate the present value of cash flows associated with the two options (using the post-tax cost of debt as the discount rate) and choose the option which has a lower present value.


PROJECT FINANCE

Project finance involves raising funds for a capital

investment project that can be economically separated

from its sponsor. The suppliers of funds depend primarily

on the cash flows of the project to service their loans and

provide return on their equity investment in the project.


FEATURES OF PROJECT FINANCE

• The project is set up as a separate company which is granted a concession by the government.

• The sponsor company which promotes the project usually takes a substantial stake in the equity of the project and enjoys the over all responsibility for running the project.

• The project company enters into comprehensive contractual arrangements with various parties like contractors, suppliers, and customers.

• The project company employs a high debt-equity ratio, with lenders having no recourse or limited recourse to the sponsor company.


Project sponsors

Project company

Suppliers

Government

Contractors

Lenders

Others

Customers

MAIN PARTIES INVOLVED IN PROJECT FINANCE ARRANGEMENTS


DISTINCTIVE FEATURE

The distinctive feature of project finance is a web of

contractual arrangements, which may change over time,

designed to distribute various risks inherent in the project

to parties best qualified to appraise and control them.

Hence project finance represents an efficient way of

allocating and managing risks


GVK POWER

GVK Industries sponsored GVK Power, the project company, to set up power project. GVK Power entered into the following contracts with various parties.

• A turnkey execution contract with ABB, Switzerland

• An operations and maintenance contract with CMS Corporation

• A power purchase agreement with APSEB

• A loan agreement with IFC, ADB, and Indian financial institutions.


SUMMING UP• A lease represents a contractual arrangement whereby the lessor grants the lessee the right to use an asset in return for periodical lease payments.

• A finance lease, or capital lease, is an intermediate term to long- term non-cancellable arrangement. An operating lease is a short- term cancellable lease.

• There are some plausible reasons for leasing and there are some dubious reasons for leasing.

• The lessor is entitled to claim depreciation for income tax purposes. The lease rentals are taxable receipts in the hands of lessors and tax-deductible expenses for the lessee.

• For accounting purposes, operating leases are capitalised in the books of the lessor whereas financial leases are capitalised in the books of the lessee.


• In finance literature, a leasing decision is commonly regarded as a financing decision.

• The NPV of a finance lease is:

• Under a hire-purchase agreement, the hirer (the counterpart of lessee) enjoys the benefits of ownership. The hirer pays periodic hire purchase instalments to the hiree (the counterpart of the lessor) which covers interest as well as principal repayment.

• The distinctive feature of project finance is the manner in which project risks are allocated to various parties involved in a project. Through a comprehensive web of contracts, every major risk inherent in the project is allocated to the party/parties that is best able to assess and manage that risk.

n LRt (1 – T ) + DEPt x Tc SVn NPV = I - - t =1 [1 + rD (1 – TC)]t [1 + rD (1 – TC)]n


Economy & Finance

Chapter30 leasinghirepurchaseandprojfinance