Module 2: Leasing ( 5 sessions)

A. Concept of Leasing
A lease may be defined as : a contractual arrangement / transaction in which a party
owning an asset / equipment (lessor) provides the asset for use to another / transfer the
right to use the equipment to the user (lessee) over a certain / for an agreed period of
time for consideration in form of / in return for periodic payment (rental) at the end
of the period of contract (lease period) ,the asset /equipment reverts back to the lessor
unless there is a provision for the renewal of the contract.
B. Evolution of Leasing Industry
Leasing activity was initiated in India in 1973. The first leasing company of India,
named First Leasing Company of India Ltd. was set up in that year by Farouk Irani,
with industrialist A C Muthia. For several years, this company remained the only
company in the country until 20th Century Finance Corporation was set up – this was
around 1980.
By 1981, the trickle started and Shetty Investment and Finance, Jaybharat Credit and
Investment, Motor and General Finance, and Sundaram Finance etc. joined the leasing
game. The last three names, already involved with hire-purchase of commercial
vehicles, were looking for a tax break and leasing seemed to be the ideal choice.
The industry entered the third stage in the growth phase in late 1982, when numerous
financial institutions and commercial banks either started leasing or announced plans
to do so. ICICI, prominent among financial institutions, entered the industry in 1983
giving a boost to the concept of leasing. Thereafter, the trickle soon developed into
flood, and leasing became the new gold mine. This was also the time when the profit-
performance of the two doyen companies, First Leasing and 20th Century had been
made public, which contained all the fascination for many more companies to join the
industry. In the meantime, International Finance Corporation announced its decision
to open four leasing joint ventures in India. To add to the leasing boom, the Finance
Ministry announced strict measures for enlistment of investment companies on stock-
exchanges, which made many investment companies to turn overnight into leasing
companies.

As per RBI’s records by 31st March, 1986, there were 339 equipment leasing
companies in India whose assets leased totaled Rs. 2395.5 million. One can notice the
surge in number – from merely 2 in 1980 to 339 in 6 years.

Subsequent swings in the leasing cycle have always been associated with the capital
market – whenever the capital markets were more permissive, leasing companies have
flocked the market. There has been appreciable entry of first generation entrepreneurs
into leasing, and in retrospect it is possible to say that specialised leasing firms have
done better than diversified industrial groups opening a leasing division.

Another significant phase in the development of Indian leasing was the Dahotre
Committee’s recommendations based on which the RBI formed guidelines on
commercial bank funding to leasing companies. The growth of leasing in India has
distinctively been assisted by funding from banks and financial institutions.
 Banks themselves were allowed to offer leasing facilities much later – in 1994.
However, even to date, commercial banking machinery has not been able to gear up to
make any remarkable difference to the leasing scenario.

The post-liberalisation era has been witnessing the slow but sure increase in foreign
investment into Indian leasing. Starting with GE Capital’s entry, an increasing
number of foreign-owned financial firms and banks are currently engaged or
interested in leasing in India

C. Types of Leases
o Financial Lease: According to the International Accounting Standard
(IAS-17) in a finance lease the lessor transfers to the lessee,
substantially all the risks and rewards incidental to the ownership of
the asset whether or not the title is eventually transferred . It involves
payment of rental over an obligatory non –cancelable lease period ,
sufficient in total to amortize the capital outlay of the lessor and leave
some profit. In such leases , the lessor is only a financier and is usually
not interested in the assets. Such leases are also called Full Payout
Leases as they enable a lessor to recover his investment in the lease
and derive a profit.
▪ Sales and lease back.
▪ Direct leasing.
▪ Leveraged leasing.
▪ Straight lease and modified lease.
▪ Primary lease.
▪ Secondary lease

o Operating Lease: According to the IAS-17 in operating lease also known as

Service Lease , the lessor does not transfer all the risks and rewards
incidental to the ownership of the asset and the cost of the asset is
not fully amortized during the primary lease, the lessor provides
services ( other than the financing of the purchase price ) attached to
the leased asset , such as maintenance , repairs and technical advice.
The lease rental in an operating lease includes :
▪ a cost for the services provided and
▪ the lessor does not depend on a single lessee for recovery of
his cost.

o Floating rental rate lease contracts.

o Domestic lease
o International lease.
o Sale –Aid lease
o Foreign to foreign lease.
D. Advantage and Disadvantage of leasing

Advantages to the lessee

▪ Financing of capital goods
▪ Additional source of finance
▪ Less costly
▪ Ownership preserved
▪ Avoids conditionalities
▪ Flexibility in structuring of rentals
▪ Simplicity
▪ Tax benefits
▪ Obsolescence risk is averted
Advantages to the lessor
▪ Full security
▪ Tax benefit
▪ High profitability
▪ Trading on equity
▪ High growth potential
Disadvantage of leasing
▪ Lease Expenses
▪ Reduced Return for equity holders
▪ Maintenance of equipment
▪ No ownership
▪ Processing and documentation

E. Content of lease agreement

Clauses of lease agreement
▪ Nature of lease
▪ Description
▪ Delivery and redelivery
▪ Period
▪ Lease Rentals
▪ Use
▪ Title
▪ Repairs and Maintenance
▪ Alteration
▪ Peaceful Possession
▪ Charges
▪ Indemnity Clause
▪ Inspection
▪ Prohibition of sub leasing
 ▪ Events of default and remedies
▪ Applicable law

F. Process of lease documentation

1. Letter of offer (To lessee by lessor to convey decision of approval)
2. Lesee is asked to sign, date and return a copy of offer letter
3. Pass resolution at a board meeting accepting the offer and approving
financial arrangement
4. Commercial documents required or Attendant Lease Documents(by lessor
from lessee)
I. Purchase order
II. Invoice
III. Bill of sale from the supplier/manufacturer
IV. Delivery note
V. Insurance policies (Custody of lessor)
VI. Consent or waiver of any interest
VII. Import License
VIII. Copy of shops and establishment certification certificate or
sales tax registration certificate
IX. Memorandum and article of association
X. Copies of Board resolution
XI. Copies of audited financial statement for last 3 years
XII. Latest Income tax return
XIII. Wealth tax return/assessment order
XIV. Letter of delegation of powers by BOD

G. Tax aspects of leasing

o Lessor:
i. Deduction of depreciation from taxable income
ii. Income from lease rentals is taxable under “Profits and Gains of
Business and Profession”
iii. Deductible expenses:
1. Depreciation
2. Rent, rates, taxes, repairs and insurance
3. Amortization of preliminary expenses
4. Interest on borrowed capital
5. Bad debts
6. All expenses incurred in furtherance of business
7. Entertainment expenses (with a cap)
8. Travel expenses (as per approved norms)
o Lessee:
1. Deductibility of Incidental Expenses – Repairs, Maintenance,
Insurance, Finance Charges,…(Incidental)
2. Installation expense (revenue expense in the year of incurrence)

H. Lease evaluation
 ▪ Calculate the present value of net-cash flow of the buying option, called NPV
(B).

▪ Calculate the present value of net cash flow of the leasing option, called NPV
(L)

▪ Decide whether to buy or lease the asset or reject the proposal altogether by
applying the following criterion:

▪ (a) If NPV (B) is positive and greater than the NPV (L), purchase the asset.

▪ (b) If NPV (L) is positive and greater than the NPV (B), lease the asset.

▪ (c) If NPV (B) as well as NPV (L) are both negative, reject the proposal
altogether.

NPV/NAL = Investment Cost

Less: PV of lease payment(discounted by Kd)
Plus: PV of tax shield on lease payment (discounted by Kc)
Less: Management Fee
Plus: PV of tax shield on management fee (discounted by Kc)
Minus: PV of depreciation shield (discounted by Kc)
Minus: PV of Interest shield (discounted by Kc)
Minus: PV of salvage value (discounted by Kc)

I. Break even rental for lessor

It represents the minimum(floor) lease rental which he can accept. The NAl/NPV at
this level of rental is zero

J. Structuring of lease rentals

The lease rentals are structed to suit the lessors and the lessees. From the lessee’s
angle, the structure of lease rental should synchronise with his operational cash flow
pattern. The lease rentals should ensure a given/expected return to the lessor.

K. Profile of lease rental

● Stepped Rentals
● Deferred Rentals
● Bell shaped Rentals

L. AS 19 and IAS 17
 M. Major players in India
▪ Independent leasing companies
▪ Other Finance companies
▪ Manufacturer Lessors
▪ Financial Institutions
▪ In house lessors
▪ Commercial banks

Question: Tel, Inc. is a telecommunication services provider looking to expand to a new

territory Z; it is analyzing whether it should install its own telecom towers or lease them out
from a prominent tower-sharing company T-share, Inc.
Leasing out 100 towers would involve payment of $5,000,000 per year for 5 years.
Erecting 100 news towers would cost $18,000,000 including the cost of equipment and
installation, etc. The company has to obtain a long-term secured loan of $18 million at 5%
per annum.
Owning a tower has some associated maintenance costs such as security, power and fueling,
which amounts to $10,000 per annum per tower.
The company’s tax rate is 40% while its long-term weighted average cost of debt is 6%. The
tax laws allow straight-line depreciation for 5 years.
Determine whether the company should erect its own towers or lease them out.
Solution
Annual cash out flows of leasing (Year 1 to Year 5) = $5,000,000 * (1 – 40%) = $3,000,000
Annual cash flows of purchasing have three components: the loan amount to be repaid in
each period, the maintenance costs to be borne each year, the tax shields associated with
maintenance costs, depreciation expense and interest expense. The following table
summarizes the calculation of cash flows under this alternative.
Equivalent annual loan instalment:18000000/4.3295= Rs 4,157,546
Period 1 2 3 4 5
Loan A 4,157,546 4,157,546 4,157,546 4,157,546 4,157,546
repayment
Maintenance B 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000
costs
Depreciation D 3,600,000 3,600,000 3,600,000 3,600,000 3,600,000
Interest I 900,000 737,123 566,101 386,529 197,978
expense
Total tax T= 5,500,000 5,337,123 5,166,101 4,986,529 4,797,978
deductions B+D+I
 Tax shield t = 0.4×T 2,200,000 2,134,849 2,066,441 1,994,612 1,919,191
@ 40%
Net cash N= 2,957,546 3,022,697 3,091,106 3,162,935 3,238,355
flows A+B–t
Annual loan repayment is based on present value calculation; it is the amount paid at the end
of each year for 5 years that would write off the loan completely. It is calculated using the
following MS Excel function: PMT (5%,5,-18000000).
Interest expense are calculated in the following debt amortization table:

Perio Opening Total Principal Closing

Interest (5%)
d Principal Repayment Repayment Principal
0 18,000,000 - - - 18,000,000
1 18,000,000 4,157,546 900,000 (18000000*5%) 3,257,546 14,742,454
2 14,742,454 4,157,546 737,123 (14,742,454*5%) 3,420,424 11,322,030
3 11,322,030 4,157,546 566,101 (11,322,030*5%) 3,591,445 7,730,585
4 7,730,585 4,157,546 386,529 (7,730,585 *5%) 3,771,017 3,959,568
5 3,959,568 4,157,546 197,978 (3,959,568*5%) 3,959,568 -
It is necessary to prepare amortization table because tax laws do not allow deduction of total
loan amount, instead only interest expense is allowed as deduction.
Depreciation is calculated on straight-line basis using the 5-year useful life (i.e.
$18,000,000/5 = $3,600,000).
Tax shield is subtracted from loan repayments and maintenance costs while calculating the
net cash outflows because tax shield represents a cash inflow which arises due to tax
deductibility of the expenses.
Now, we have to calculate the present value of cash outflows under both the options using the
after-tax cost of debt which is 3.6% (6% * (1-40%))
Present value of leasing at 3.6% = $13,545,157 (5000000*.6*4.515)
Present value of purchasing =$15,472,639
Since leasing has a lower present value of cash outflows, it should be the preferred
option.