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Asset-Based Financing:

Lease, Hire Purchase and Project Financing

Lease Defined

  • Lease is a contract under which a lessor, the owner of the assets, gives right to use the asset to a lessee,

the user of the assets, for an agreed period of time for a consideration called the lease rentals.

  • In up-fronted leases, more rentals are charged in the initial years and less in the later years of the contract. The opposite happens in back ended leases.

  • Primary lease provides for the recovery of the cost of

the assets and profit through lease rentals during a

period of about 4 or 5 years. It may be followed by a perpetual, secondary lease on nominal lease rentals.

Types of Leases

  • Operating Lease

  • Financing Lease

  • Sale and Lease Back

Operating Lease

  • Shot-term, cancelable lease agreements are called operating 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.

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.

Cash Flow Consequences of a

Financial Lease

  • Avoidance of the purchase price.

  • Loss of depreciation tax shield.

  • Aftertax payments of lease rentals.

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.

Commonly Used Lease Terminology

  • Leveraged Lease.

  • Cross-border lease.

  • Closed and open ended lease.

  • Direct lease.

  • Master lease.

  • Percentage lease.

  • Wet and dry lease.

  • Net net net lease.

  • Update lease.

Myths about Leasing

  • Leasing Provides 100% Financing

  • Leasing Provides Off-the-Balance-Sheet Financing.

  • Leasing Improves Performance.

  • Leasing Avoids Control of Capital Spending.

Advantages of Leasing

  • Convenience and Flexibility.

  • Shifting of Risk of Obsolescence.

  • Maintenance and Specialized Services.

Evaluating a Lease

  • Equivalent Loan Method.

  • Net Advantage of a Lease Method.

  • IRR Approach.

Equivalent Loan Method

  • EL is that amount of loan which commits a

firm to exactly the same stream of fixed obligations as does the

lease liability.

  • Method

    • 1. Find out incremental cash flows from leasing.

    • 2. Determine the amount of equivalent loan such cash flow can service.

    • 3. Compare the equivalent loan so found with lease finance.

EL

n

t 1

1

t L TDEP

t

1

i

1

t

t

Net Advantage of a Lease Method

  • 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.

    Combination of Net Present Value of Investment and Net Advantage of Leasing

    Situation

    (a) NPV of Investment

    (b) Net Advantage of Leasing

    Decision

    1

    Positive

    Positive

    Lease

    2

    Positive

    Negative

    Buy

    3

    Negative

    Negative

    Reject

    4

    Negative

    Positive

    Lease if

    a>b

    Lease Benefits to Lessor and Lessee

    • A lease can benefit both when their tax rate differs.

    • Leasing pays if the lessee’s marginal tax rate is less than that of the lessor. In fact in a lease, the lessee sells his depreciation tax

    shield to the lessor.

    • In the absence of taxes it is hard to believe that leasing would be advantageous if the capital markets are reasonably well functioning.

    • Gain of both is loss to the government in form of taxes.

    Internal Rate of Return Approach

    • IRR of a lease is that rate which makes NAL

    equal to zero.

    • 1. A o

    = Purchase Price.

    • 2. = Lease Rentals.

    L

    • 3. DEP = Depreciation

    • 4. = Tax Rate

    T

    • 5. = Operating Cost

    OC

    • 6. = Salvage Value

    SV

    A

    o

    n

    t 1

    1

    

    T L OC

    t

    TDEP

    t

    1

    r

    t

    SV

    n

    1

    r

    n

    0

    Hire PurchaseConditions

    • The owner of the asset (the Hirer or the manufacturer) gives the possession of the asset to the Hirer with an understanding that the Hirer will pay agreed instalments over a specified period of time.

    • The ownership of the asset will transfer to the

    hirer on the payment of all instalments.

    • The Hirer will have the option of terminating the agreement any time before the transfer of ownership of assets. ( Cancellable Lease)

    Difference

    Hire Purchase Financing

    Lease Financing

    Hirer is entitled to claim

    Lessee is not entitled to claim

    Depreciation Tax Shield.

    depreciation tax shield.

    Hirer can charge only interest Portion.

    Lessee can charge the entire lease payments as expense for tax computation.

    Once the hirer has paid all instalments, he becomes the owner of the asset and can

    Lessee does not become the owner of the asset. Therefore he has no claim over the asset

    claim its salvage value.

    salvage value.

    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.

    Project Financing

    • Scheme of financing a particular economic unit in which a lender is satisfied in looking at the cash flows and the earnings of that economic unit as a source of funds, from which a loan can be repaid and to the assets of the economic unit as a collateral for the loan.

    • It is different from the traditional form of financing, i.e., the corporate financing or the balance sheet financing.

    Characteristics

    • A separate project entity is created that receives loans from lenders and equity from sponsors.

    • The component of debt is very high in project financing.

    • The project funding and all its other cash flows are separated from the parent company’s balance sheet.

    • Debt services and repayments entirely depends on the project’s cash flows. Project assets are used as collateral for loan repayments.

    • Project financer’s risk are not entirely covered by the

    sponsors guarantees.

    • Third Parties like suppliers, customers. government and sponsors commit to share the risk of the project.

    Project Financing Arrangements

    • The Build Own Operate Transfer Structure.

    • The Build Own Operate Structure.

    • The Build Lease Transfer Structure.

    Project Financing Risk and their

    Allocation

    • Risks

      • 1. Project Completion Risk

      • 2. Market Risk

      • 3. Foreign Currency Risk

      • 4. Inputs Supply Risk

  • Risk Mitigation

    • 1. By Government

      • 1. Country Risk

      • 2. Sector Policy Risk

    • 2. By Others

      • 1. Commercial Risk