Discusses

1. LEASING
An Overview

2. Characteristics
Periodical payment of rentals
 Lessor Lessee
Right to use an asset for
a fixed period of time
Ownership rests with the lessor

3. Term
 Lease Period = Lease agreement is
operational
 Perpetual lease
Primary
 Lease Period
Secondary

4. Tests for Financial Lease
Substance Test: Lessee Compliance with No.2 point
Full Payment Test: Lessor Compliance with No.8 point
–
Transfer of Title Test: Lessee has an option to buy the
asset
Lease Term Test: Lease term extends to the asset’s
life

5. Myths about Leasing
 Off-balance sheet financing
 No evaluation for capital expenditure – Cash flow
consequences?
 Better Performance – Possible to enhance ROI, but
the transaction should yield a positive
NPV

6. Advantages of Leasing
 Advantages to the lessor:
1. Stable Business – Lessee’s continued patronage
2. Sale of spare parts
3. Second-hand market
4. Tax benefits
5. Fillip to capital market
6.Easy finance

7. Advantages of Leasing
 Advantages to the Lessee:
1. Efficient use of funds - No capital investment
2. Cheaper Source - than buying option
3. Enhanced borrowing capacity - Lower D/E Ratio
4. Off-balance sheet borrowing - - do -
5. Tax benefits
6. Guard against obsolescence - Lessee can terminate the
lease at any time
and take up another
asset under fresh
lease

8. Limitations
 Disguised form of debt financing
 Loss of depreciation tax shield, when depreciation
rates are high and leasing is preferred over buying
 Possibility of double sales tax in certain states
 Unfavourable capital gearing for the lessee
 No ownership
 Default Risk
 Working Capital not considered
 Indiscriminate finance

9. Tax Aspects of Leasing
 Lessor:
 Deduction of depreciation from taxable income
 Income from lease rentals is taxable under “Profits and Gains
of Business and Profession”
 Deductible expenses:
 Depreciation
 Rent, rates, taxes, repairs and insurance
 Amortization of preliminary expenses
 Interest on borrowed capital
 Bad debts
 All expenses incurred in furtherance of business
 Entertainment expenses (with a cap)
 Travel expenses (as per approved norms)
 (See Illustration No.3.5 M Y Khan)

10.  Lessee:
 Allowability of lease rentals – allowed as normal
business expenditure if they are not i. of capital nature, ii.
Personal expense and relates only to the business purpose.
 Deductibility of Incidental Expenses – Repairs,
Maintenance, Insurance, Finance Charges,…(Incidental)
Installation expense (revenue expense in the year of
incurrence)

11. Tax Planning
 Lessee:
 Flexible Restructuring of Lease Rentals –
 Substantial part of the lease rentals payable in the first year and
a very small fraction during the remaining lease term
 Lower rentals in earlier years and higher in later years depending
on cash flows
 Purely tax-driven structure of lease rentals not allowed by the IT
authorities
 (See Illustration No.3.6 M Y Khan)
 Transfer of Investment-related Unabsorbed Tax Shield –
 Lessee firm enjoys 100% tax deduction (exports) – Tax shield on
fresh capital investment would not have any impact on its cash
flows – Tax shields can be transferred to the lessor who will
consider lower lease rentals
 (See Illustration No.3.7 M Y Khan)

12. Funding Aspects of Leasing
 Deposits – Major source of finance
 Bank Borrowings –
 Maximum Limit – 10 times of NOF including deposits,
borrowings from banks/FIs, debentures, bonds
 Maximum bank borrowings would be 3 times of NOF where
75% of the company’s assets are in equipment leasing and
where 75% of its gross income is from leasing
 NOF = Paid up Capital + Free Reserves – Accumulated
balance of loss, where Free Reserves represent share
premium account, capital and debenture redemption reserves
and any other reserve not created for payment of any future
liability or for depreciation in assets or for bad debts or a
reserve created by revaluation of assets
 RBI has freed the restrictions w.e.f.April 1997

13.  Nature of Facility – based on the expected flow of lease
rental receivables
 Maximum Permissible Bank Finance –
 Calculate outstanding credit for next five years
 Calculate relevant Drawing Power against that particular
transaction
 Exclude – a. Funds raised from financial/inv. Institutions
b. DPGs provided by banks, and c. Assets created against
DPGs issued by banks
This will imply bank finance will be to an extent of 2 – 3
times of NOF.

14.  Requirements for Bank Finance
 Current Ratio – Minimum 1.33
 Reports - (See page no. 203 Dr S Gurusamy)

15. Lessee’s Perspective of Leasing
 Lease rental payments are similar to payments of
interest on debt
 Hence, alternative to borrowing
 Choice between debt financing versus lease financing
 Decision-criterion – Net Present Value of Leasing/Net
Advantage of Leasing – NPV(L)/NAL
 Discount Rate used is the marginal cost of capital for
all cash flows except lease payments and tax cost of
debt for lease payments
 Value of interest tax shield is included as a foregone
cash flow in the computation of NPV(L)/NAL

16. NPV(L)/NAL
 NPV(L)/NAL = Investment Cost
- PV of lease payment (discounted by Kd)
- PV of tax shield on lease payment (discounted by
Kc)
- Management Fee
+ PV of tax shield on management fee (disc.by Kc)
- PV of Depreciation shield (discounted by Kc)
- PV of Interest Shield (discounted by Kc)
- PV of residual/salvage value (discounted by Kc)
Where Kc = Post-tax marginal cost of capital, and
Kd = Pre-tax cost of long-term debt

17.  NPV(L)/NAL negative means leasing alternative
should be used.
 NPV(L)/NAL positive means borrowing alternative
would be preferable.
 Alternative approach is
 Determine the PVs of cash outflows after taxes under both the
alternatives
 Select the alternative with the lower PV of cash outflows
 (See Illustration No.4.1 M Y Khan)

18. Break-Even Lease Rental (BELR)
for lessee
 The point where the Net Advantage of Leasing (NAL)
is zero.
 The rental at which the lessee is indifferent between
lease financing and borrowing/buying.
 Maximum level of rental which the lessee is willing to
pay
 If the BELR > the actual rental, the lease proposal
would be acceptable.
(See Illustration No. 4.4 M Y Khan)

19. Lessor’s Perspective of Leasing
 Whether to accept a lease proposal, or to
choose from alternative proposals
 Determine break-even rental for the lessor,
negotiation and fixation of lease rentals
(See Illustration No.4.5 M Y Khan)
• BELR for a lessor – minimum lease rental which he
can accept
• NAL/NPV(L) at this level of rental is zero.
• Discount Rate to compute NAL is the marginal over-all
cost of funds to the lessor
(See Illustration No. 4.6 M Y Khan)