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Rashmi Mehta 208 Ishan Modi 210 Anshum Kawatra 308 Arpan Mehra - 309
Types of Lease
Financial Lease Operating Lease Leverage Lease Sale and Lease back Cross Border Lease
Advantages of Lease
Permit alternative use of funds Faster and cheaper credit Flexibility Facilitate additional borrowing Protection against obsolescence Hundred percent financing Boon to small firm
Financial Lease
Irrevocable and non-cancellable contractual agreement. Lessee uses the asset exclusively for a relatively longer period, maintains it, insures and avails of the after sales service and warranty backing it. Lessee bears the risk of obsolescence as it stands committed to pay for entire lease period.
Contd.
Financial lease with the purchase option, where at the end of pre-determined period, the lessee has the option to buy the equipment / asset at a pre-determined value. The leasing company / lessor charges nominal service charges to lessee towards legal and other costs.
Operating Lease
Contractual period between lessor and lessee is less than full economic life of equipment i.e. short-term in nature. The lease is terminable by giving stipulated notice as per the agreement. The risk of obsolescence is enforced on the lessor who will also bear the cost of maintenance and other relevant expenses.
Leverage Lease
Arrangement for assets of huge capital outlay. Parties involved are (a) Lessor (Max. 20 50% stake) (b) Lessee (As in operational lease) (c) Lenders (Rest stake holders) Lessor acquires the asset with maximum contribution upto 50% and rest is financed by lenders secured by mortgage of the asset besides assignment of leased rental payments.
Disadvantages of Leasing
Lease rentals are payable soon after entering into lease agreement while in new projects cash generation may start after gestation period. The cost of financing is higher than debt financing. If the lessee defaults in payment, lessor would suffer a loss.
Problems of Leasing
Unhealthy Competition Lack of qualified personnel Tax Considerations Stamp Duty Delayed Payments and Bad Debts
Calculation Procedure
Calculate the present value of post-tax cash flows associated with the cash flows associated with the ownership and operation of the car. The post-tax cash flows associated with the car are shown in table. The present value of cash flows is Rs. 1.204 million. Convert the present value obtained in step 1 into post tax equivalent annual cost (EAC). the post- tax EAC works out to: PV of costs = 1.204 = Rs. 0.326 million PVIFA 3.696 Adjust post tax EAC for tax factor to g et lease rental Lease rental = Post-tax EAC = 0.326 = Rs. 0.502 million Tax rate 1 - 0.35
Initial Cost Operating and other costs Depreciation Tax shield on operating costs and depreciation Net salvage value Post-tax cash flow (1+2+4+5) Discount factor (at 11 %) Present Value
-1.2 - 0.2 0.48 0.238 -0.216 0.288 0.176 -0.233 0.173 0.142 -0.252 0.104 0.125 -0.272 0.062 0.117 0.400 -1.2 1 -1.2 0.038 0.901 0.034 -0.04 0.812 -0.032 -0.091 0.731 -0.067 -0.127 0.659 -0.084 0.245 0.593 0.145
Other Considerations
ABC of course will have to charge an annual lease rental more than 0.502 million to cover
Cost of negotiating and administering the lease contract periodically It as to forgo the revenues wen car is idle and offlease It as to bear the risk of diminishing appeal of the car over a period of time
An operating lease offers valuable options to the lessee. For e. g. suppose ABC offers XYZ two proposals:
A one year lease for Rs. 0.520 million A 5-year lease for Rs. 0.540 million with the option to cancel the lease any time after 1 year
Although the second proposal is costlier, it has some attractive features, if lease rates increase after one year, XYZ can continue at the old rate and if the lease rates decline, XYZ can cancel the lease and get a better rate.
If Vitex leases the fork lift the financial implications are as follows:
Vitex saves Rs. 10 million, the cost of the forklift. This is equivalent to cash inflow at the end of year 0. Vitex not being owner of the forklift cannot claim depreciation on it. Hence it loses the depreciation tax shield. Further Vitex does not get the salvage value at the end of 6 years. Vitex must pay Rs. 2.4 million per year to Anupam leasing , the first payment is due at the end of year 1. The lease payment of Rs. 2.4 million per year represents a tax deductible expense generating a tax shield of Rs. 0.96 million per year.
Initial Cost Depreciation Loss of Tax shield on depreciation Lease Payment Tax Shield on lease payment Loss of salvage value Cash flow
0 10
1 4 -1.4
2 2.4 -0.84
3 1.44 -0.5
4 0.86 -0.3
5 0.52 -0.18
6 0.31 -0.11
-2.4 0.84
-2.4 0.84
2-.4 0.84
-2.4 0.84
-2.4 0.84
10
-2.96
-2.40
-2.06
-1.86
-1.74
-2.67
The post-tax borrowing for Vitrex is equal to 15.4 x (1- 0.35) = 10%
Since the lease has a negative NPV Vitex is better of buying the forklift from a purely financial point of view.
IRR
Therefore irr = 10.2 % Since this figure is higher than the post-tax cost of debt (10 %) leasing is a costlier option.
HIRE-PURCHASE METHOD
Definition
Hire purchase is a type of instalment credit under which the hire purchaser, called the hirer, agrees to take the goods on hire at a stated rental, which is inclusive of the repayment of principal as well as interest, with an option to purchase.
FEATURES
Hire Purchase is an agreement to hire an asset over a predefined
immediately & agrees to pay the total hire purchase price in instalments
In case the buyer makes any default in payments of any instalments
FINANCIAL EVALUATION
STEPS involved in choosing between leasing and HirePurchase options are:1. Estimate the post tax cash flows associated with each option
a) a) Leasing - LRn(1-Tc) Hire Purchase - In(1-Tc) PRn + Dn(Tc) + NSVn
2. Calculate the present value of cash flows associated with the two options. Choose the option which has lower present value.
FINANCIAL EVALUATION
COST of HIRING
- Down payment + service charges + PV of hire purchase payments PV of depreciation tax shield - PV of net salvage value
COST of LEASING
- Lease management fee + PV of lease payments PV of tax shield on lease payments + PV of interest tax shield on hire purchase
EXAMPLE
Q. Narmada finance offers a Hire purchase plan for corporate borrowers
Rate of interest Repayment Down payment
Calculate APR (annual percentage rate) by trial error & approximation approach. What would be the answer if payment is in advance.
SOLUTION
Amount of loan 800 Total charge for credit 800 * 0.13 * 3 = 312 Monthly installment (800 + 312) / 36 = 30.89 (30.89 * 12 ) * PVIFA p (i,3) = 800 i / i 12 * PVIFA (i,3) = 2.158 LHS = 2.191 LHS = 2.143
For i= 24 For i= 26
i= 25.38
Approximate formula 36/37 * 2 * 13 = 25.3%
Solution Contd.
(30.89 * 12 ) * PVIFA p (i,3) = 800 i / d 12 * PVIFA (i,3) = 2.158 For i= 26 LHS = 2.185 For i= 28 LHS = 2.141 i= 27.23%
Increasingly, many small businesses are beginning to lease computers, photocopiers and fax machines. Not only does it help to reduce the upfront cash needed to purchase these items, but it also shifts the responsibility and cost of maintenance and servicing to the supplier.
DIFFERENCE
HIRE PURCHASE SALE
The hirer has the option to purchase the goods anytime during the term of the agreement. He also has the right to terminate the agreement at anytime before payment of the last instalment.
OWNERSHIP
a) Ownership is passed to the hirer only if he exercises the option to purchase. b) The ownership of the equipment passes to the hirer on payment of the last instalment. c) The lessee, not being the owner of the asset, does not enjoy the salvage value of the asset.
OWNERSHIP
a) Ownership is transferred to the purchaser on payment of the first instalment.
b) The lessor company is the owner and the lessee is entitled only to the use of the leased equipment.
c) The hirer, being the owner of the asset, enjoys the salvage value of the asset. TAX BENEFITS The lessor is allowed to claim depreciation and lessee is allowed to claim any interest on borrowed funds to claim rentals and maintenance cost. Against taxable income.
TAX BENEFITS Hirer is allowed the depreciation claim and finance charge and the seller may depreciation and lessee is allowed to claim rentals and maintenance cost acquire the asset for tax purposes.
DIFFERENCE
HIRE PURCHASE
MAINTENANCE
Cost of maintaining the hired equipment is to be borne by the Lender.
LEASE FINANCE
MAINTENANCE
Maintenance of the leased asset is the responsibility of the lesse.
EXTENT
20-25% of the cost of the equipment is required to be paid by the hirer as down payment.
EXTENT
No down payment is required from the lessee.
MAGNITUDE
The magnitude of funds involved is relatively low as compared to buying the asset.
MAGNITUDE
The magnitude of funds involved is very small. EXAMPLE Aircrafts, ships, machinery are taken on financial lease.
EXAMPLES
Automobiles, generators, office equipment etc. are usually hire purchased.
When is it best to purchase a capital asset by paying cash or by getting a bank loan or by leasing?
DECIDE (1) the type of asset the company needs (2) whether it is new or used (3) the purchase cost (4) the amount of the down payment, if any (5) the length of finance term (6) the payment method/procedure/preference.
the availability of cash opportunity cost other investments available, tax benefits obsolescence of the asset.
EXAMPLE
Nidhi finance in addition to hire purchase proposal, offers a lease proposal Asset value Rs. 1 million Primary lease period 5 years Lease rentals Rs. 300 per 1,000 per year Secondary lease period 5 years Lease rental Rs. 12,000 Net salvage value of the asset after 10 years Rs. 100,000 Post tax cost of debt 8% Tax rate 50 % Depreciation 33.5 %