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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.

2
Types of Leases
 Operating Lease
 Financing Lease
 Sale and Lease Back

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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.

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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 lease–Capital or Full pay-out leases.

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Cash Flow Consequences of a
Financial Lease
 Avoidance of the purchase price.
 Loss of depreciation tax shield.
 After–tax payments of lease rentals.

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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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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.

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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
 Convenience and Flexibility.
 Shifting of Risk of Obsolescence.
 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
loan which commits a
firm to exactly the
same stream of fixed
obligations as does the
lease liability.
 Method—   1  t  L  TDEPt  
n
EL    
1. Find out incremental
cash flows from leasing. t 1

 1  i 1  t   t 

2. Determine the amount of
equivalent loan such
cash flow can service.
3. Compare the equivalent
loan so found with lease
finance.

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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.

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 Combination of Net Present Value of
Investment and Net Advantage of Leasing
Situation (a) NPV of (b) Net Advantage Decision
Investment of Leasing
1 Positive Positive Lease
2 Positive Negative Buy
3 Negative Negative Reject
4 Negative Positive Lease if
a>b

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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.
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Internal Rate of Return Approach
 IRR of a lease is that rate which makes NAL
equal 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

Ao  
n
 1  T  L  OC  t  TDEPt 

SV n
0
1  r  1  r 
t n
t 1

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Hire Purchase–Conditions
 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)

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

Once the hirer has paid all Lessee does not become the
instalments, he becomes the owner of the asset. Therefore
owner of the asset and can he has no claim over the asset
claim its salvage value. salvage value.

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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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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.

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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.

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Project Financing Arrangements
 The Build Own Operate Transfer Structure.
 The Build Own Operate Structure.
 The Build Lease Transfer Structure.

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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

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