ANALYSIS OF VARIOUS MODELS OF LEASE EVALUATION

ANALYSIS OF VARIOUS MODELS OF LEASE EVALUATION

103 CHAPTER - V ANALYSIS OF VARIOUS MODELS OF LEASE EVALUATION A) Lease Evaluation Models : Most of the literature on leasing originated from the United States. The literature on lease evaluation models can be divided into two namely: 1. Lease vs. buy (purchase) analysis and 2. Lease vs. borrow analysis. However, there is substantial disagreement in the literature on lease evaluation models as regards to the discount rate to be used in lease evaluation by the lessee. Gant termed the lease as rented capital asset, is financed by means of leases. He quoted lease financing, stripped of its illusions, was not a fresh approach to the acquisition of fixed assets at all, but merely an old friend in disguise. He contended that lease financing is essentially a form of debt financing. Lease financing is essentially a form of borrowing, perhaps borrowing an asset rather than funds with witch are substantially the same as those incurred in borrowing money. Lease creates a commitment on the part of the company to make a series of payments over a future period to time, which is as much a fixed obligation as the interest and sinking fund requirements. There was evidence of growing awareness among investors and financial analysis of significance of lease commitments and this must be inevitably be reflected in accounting charges. Ferrare is one of the authors who had developed a lease vs. borrow model. He stated that investment and financing decisions should be kept separate. However, he argued that a financial lease is a combination of borrowing and investment and recommended cost of borrowing rate is the discount rate to find out the net present value of leasing and purchasing.

Johnson and Lowilen tried to solve the lease vs. buy problem explicitly placing themselves on the firm goal. They argued that firm should choose the type of asset and form of acquisition that provide the maximum gains to the shareholders of the enterprise. They capitalised the cash flows at the firms cost of capital because it was impassible to associate a scientific investment project with specific financing method even though, if they occur simultaneously. Also stated that the firms cost of capital should reflect the long run debt equity proportion chose by the firm. They considered a financial lease to be an acquisition of services arrangement, that is equivalent to purchase arrangement. Biemian discussed four lease evaluation techniques and recommended the after tax borrowing rate rather than firms cost of capital as discount rate. He preferred purchase to lease. B) Lease Evaluation : Some Considerations In considering the acquisition of a capital asset, however it is to be financed whether by outright purchase, leasing or in another manner, a lessor will first make an assessment of the return on the investment. The decision will be taken with the help of discounted cash flow's (DCF) which will determine whether or not the equipment is to be acquired at all. Having determined to make an investment, the next step will be to consider the relative merits of the different methods of finance available. There are many ways of quoting rentals. Generally, rentals are payable monthly or quarterly over the primary lease period. The majority of rental quotations are given on the basis of Rs. X per Rs. 1,000 per month of equipment cost. Problems arise when implicit interest rates rather than amounts are used. Some of the rates are highly misleading and are often inadequately explained by leasing companies. There are two main causes of confusion, (a) the use of true and flat rates, and (b) the compounding assumptions adopted.

105 1. Flat Rates Traditionally, finance and leasing companies used a flat rate approach to change for installment and credit facilities. The rental of Rs. 728.07 shown in Table 5.1 represents a true lease rate (implicit interest rate) of 18.5 percent ( compounding monthly in arrears). The equivalent flat rate is only 10.35 percent per annum. As a rough check or rule of thumb, the true rate is twice the flat rate less 1 percent. In the example, the calculation ( 10.35% *2)-l% = 19.7% is a way of roughly checking on the true rate of 18.5%. A rate quotation of 10.35% looks attractive as compared to 18.5%. But a 10.35% flat rate is more expensive than 18.5% true. As observed in the recent past, the misleading use of flat rate is disappearing but there is still a long way to go. TABLE-5.1 CALCULATION OF A FLAT RATE Lease Term Cost of equipment Rental per month Total rentals (36*728) Total interest (Rs. 26,208-20,000) 6,208*100 Flat rate = ----------------- 20,000*3 36 months Rs. 20,000 Rs. 26.208 Rs. 6,208 10.35% Table 5.2 compares true rates (compounding montlilv) and flat rates for loan term of two through seven years for rentals payable in arrears and Table 5.3 and 5.4 show the same comparison maintaining the 18.5% per annum true rate for rentals payable in advance.

106 TABLE 5.2 RENTALS PAYABLE MONTHLY IN ARREARS Equipment cost Rs. 20.000 lease Term Number of Rental (Rs.) True lease Flat Rate (%) (Years) rentals Rate (%) 2 24 1,003.32 18.5 10.20 3 36 728.07 18.5 10.35 4 48 592.74 18.5 10.56 5 60 513.32 18.5 10.80 6 72 461.83 18.5 10.04 7 84 426.24 18.5 11.29 Equipment cost Rs. 20.000 TABLE 5.3 RENTALS PAYABLE MONTHLY IN ADVANCE lease Term (Years) Number of Rentals Rental (Rs.) True lease Rate (%) Flat Rate (%) 2 24 988.09 18.5 9.29 3 36 717.02 18.5 9.69 4 48 583.74 18.5 10.02 5 60 505.53 18.5 10.33 6 72 454.82 18.5 10.62 7 84 419.77 18.5 10.90 The essence of the difference between a flat rate and a true rate is that flat rate calculation ignores the fact that the lessor s capital investment reduces during the lease term. It assumes, incorrectly that the original capital investment remains unchanged throughout the lease term.

107 2. Compounding Periods Interest is compounded at different frequencies so that there are several true rates for any series of rental payments. In these illustrations, the 18.5% rate is known as the annual nominal interest rate i.e. 20.2% per annum rounding to the decimal place. With the high interest rates, the period of compounding is of crucial importance when comparing rental quotations based on rates rather than amounts. 3. Calculating Rentals The leases provide for level rental payments over the lease term. The periodic payments are calculated in the same way as an annuity or mortgage repayment using tables, a suitable calculator or computer. The basic approach to rental calculations can be extended to incorporate the lease management fees, front ended arrangement and commitment fees and annual management fees and other lessee charges such as recovery of insurance expenses, and also to incorporate lessor out goings such as commissions payable, on introductions. However, once tax considerations came into pay, the formulae and financial calculations have to give way to computer programs specially designed to reflect the net of tax cash plans. Fixed and Variable Rentals It has been assumed that the rentals once established at the inception of the lease, say fixed in amount for the whole of the lease term. Neither the lessor nor the lessee is entitled to change the amounts of the rental payments. 4. Types of Variation The most usual reason for varying rentals is for changes in the lessor s cost of capital. However, lease rental may be varied for changes in many other assumptions such as exchange rates, monetary controls, tax, rates and depreciation allowances, timing of expenditure and in some high ticket leases for any factor affecting the lessor s cash flow'.

Rentals on small ticket leases are usually fixed for changes in the cost of capital while medium and bijg ticket transactions can have either fixed or variable rentals depending on the availability of fixed cost hinds to the leasing company and other money market conditions. Rentals, which are variable for changes in money costs are usually linked to fluctuating short or medium tenn money interest rates- the rates at which banks will offer hinds to each other for periods of three, six or twelve months. They may also be linked to other rates such as bank or finance company base rates which however are in turn often directly or indirectly related to money markets rates. Interest Variation Calculations It is necessary to break down each rental payments into its two components, the fixed charge, the variable ( or interest) element. The fixed charge recovers the lessor s capital investment and is the equivalent of the principal element of annuity payment. The balance payment represents the recovery of the carrying charge of the investment and profit contribution. Table 5.5 shows the break-down between the fixed charge and variable element for a lease equipment costing Rs. 1,000,000 with rental payable quarterly in arrears over the three year lease term and yielding the lessor and giving the lessee an implicit cost of (i) 10% (ii)15%, and (iii) 20% per annum (compounding quarterly). The simplest method of varying rentals for changes in money costs is to adjust the variable element of each rental of each rental for difference between the assured and actual yield rates. For any change in the base rate, the corresponding increase or decrease to the element is calculated by applying the higher or lower yield rate to the outstanding investment balances.

109 TABLE 5.4 DIFFERENT COMPOUNDING PERIODS Compounding Period Nominal Rate (%) Effective Rate (%) Nominal Rate (%) Effective Rate (%) Monthly 18.5 20.2 17.1 18.5 Quarterly 18.5 19.8 17.3 18.5 Semi-annually 18.5 19.4 17.7 18.5 Annually 18.5 18.5 18.5 18.5 5. Calculation Formulae : Formulae for Rental Calculations : Formula (0 <ii> Legend pv n : i : a = pmt = present value of lease facility number of periods (periodic rentals) in lease term interest rate per period rental factor rental amount pmt pv a where rentals are payable in arrears, a = 1-[_J I (L±I)n (iii) where rentals are payable in advance, l-l-l 1 a = fl +/)n-x + x i and x = the number of rentals payable in advance, This formula assumes that after payment of the advance rental or rentals, the list of the remaining rentals is paid at the beginning of the second period.

no Calculation of Monthly Rental in Arrears Assumptions 1. Lease facility'for equipment costing (PV) = 20,000 2. Three year lease term (n) = 36 3. Nominallease rate of 18.5% per annum, compounded monthly, i /= 18.5 100 * 12-0.015417 Calculation l-l I ] a = (1+0.015417)36 0.015417 1 1- L734580 = 0.015417 1-0.576508 = 0.015417-27.469725 pv Rs. 20,000 Rental amount = pmt = a 27.469725 = Rs. 728 Calculation of Monthly Rental in Advance Assumptions As for Table (4.6 but with one rental payable at the commencement of the lease term and 35 rentals payable monthly thereafter commencing at the beginning of the second month) Calculation a = 1 1-1( 1+0.015417)36-1 ] 0.015417

Ill... -PY- Rental amount = pmt = a I 1 1.708245 + 1 0.015417 1-0.585396 + 1 0.015417 27.893216 Rs. 20.000 = 27.893216 = Rs. 717.02 Calculation of Monthly Rental With Three Payments in Advance Assumptions As for Table 4.7 (but with three rentals payable at the commencement of the lease tenn and 33 remaining rentals payable monthly thereafter commencing at the beginning of the second month) Calculation 1 IzL ( 1+ 0.015417)36.1 1 a = 0.015417 1 1-f 1.656767 ] 0.015417 + 3 = 1-0.603585 0.015417 + 3 = 28.713399 py_ Rs. 20.000 Rental amount = pmt = a - 28.713399 Rs. 696 Formulas for Calculation of Monthly Rental, Taking into Account a Residual Value Legend fv = future value n = number of ( periods rentals) in lease term i = interest rate per period p = discount factor pv = present value of the future value after n periods

112 Formulae (i)v = 1 0 + i) (ii) pv = iv X p =Jy (1+i) (iii) pmt = pv-pv a where pv = the present value of the lease facility Calculations of Monthly Rental, Taking into Account a Residual Value Assumptions 1. Lease facility for equipment costing Rs. 20,000 pv = 20,000 2. Three year lease term = n = 36 3. Nominal lease rate of 18.5% per annum, compounded monthly i = 18.5 100 * 12 = 0.015417 4. Residual or final value is Rs.2,000 fv = 2,000 Calculation 2.000 pv= (1+0.015417) = 2000 1.734580 = Rs. 1,153.02 Rs. 20.000-Rs. 1.153.02 Rental amount = pmt = 27.469725 = Rs. 686 C) EVALUATION BY LEASING COMPANIES (LESSORS) The lease rentals quoted by leasing companies vary' widely form one company' to another depending not only upon the profile of the clients, their tax and depreciation planning cash flows and lease period but also upon the cost structure of the leasing companies. The weighted as well as individual cost of capital may differ front one

113 company to other. The cost structure of the leasing company plays a significant role in determining the lease rental quotes. Let us consider the lease rental quoted by some of the leasing companies. Presently, a New Delhi based leasing company quotes at 28/1,000, i.e. lease rental of Rs.28 per month for a leased equipment worth of Rs. 1,000 for a lease of 5 years primary period, an Alimedabad based company quotes at 27/ 1,000, a Chennai based company quotes Rs. 26/1,000, Mumbai based company quotes at Rs. 25/1,000, a subsidiary of a nationalised bank quotes at Rs. 24/1,000 for the same lease terms. The following example explains how to calculate break-even rentals by the lessor. Rs. 26/1000, Mumbai based company quotes at Rs. 25/1000, a subsidiary of nationalised bank quotes at Rs. 24 T 000 for the same lease terms. The following example explains how to calculate break-even rentals by the lessor. TABLE 5.5 THE COMPONENTS OF A RENTAL (IN RUPEES) (i) 10% (ii) 15% (ill} 20% Quarter Fixed Charge Variable Element Total Rental Fixed Charge Variable Element Total Rental Fixed Charge Variable Element Total Rental 1. 72,487 25,000 97,487 67,512 37,500 105,012 62,825 5,000 112,825 2. 74,299 23,188 97,487 70,044 34,968 105,012 65,967 46,858 112,825 3. 76,157 21,330 97,487 72,671 32,341 105,012 69,265 43,560 112,825 4. 78,061 19,426 97,487 75,396 29,616 105,012 69,265 43,560 112,825 5. 80,012 17,475 97,487 78,223 26,789 105,012 76,365 36,460 112,825 6. 82,013 15,474 97,487 81,157 23,855 105,012 81,183 32,642 112,825 7. 84,063 13,424 97,487 84,200 20,812 105,012 84,192 28,633 112,825 8. 86,164 11,323 97,487 87,357 17,655 105,012 88,401 24,424 112,825 9. 88,319 9,168 97,487 90,633 14,379 105,012 92,822 20,003 112,825 10. 90,526 6,961 97,487 9^,032 10,980 105,012 97,463 15,362 112,825 11. 92,790 4,697 97,487 97.558 7,454 105,012 102,336 10,489 112,825 12. 95,109 2,378 97,487 101,217 3,795 105,012 107,453 5,372 112,825 1.000.000 169.844 1.169.844 1.000.000 260.144.260.144 1.000.000 353.900 1.353.900

114 1. Cost of the equipment to be lease 2. Lease management fee 3. Primary lease period 4. Secondary lease period 5. Secondary period lease rentals 6. Transfer price 7. Capital structure 8. Depreciation rate 9. Tax rate of lessor Rs. 8,00,000 2 per cent of the cost 5 yeans (6 months) 3 years (6th through 8th year) Rs. 1,000 per annum in advance 1 per cent of the equipment cost (a) Equity 30 per cent of capital structure and its cost is 20 percent (b) Debt us 70 percent of capital status and its cost is 17 percent 331/2 per cent 50 per cent With the help of the above particulars, let us find out the determination of lease rentals to be recovered by the lessor during the primary period and how the lessor (leasing company) quote the lease rentals for the primary period. This depends upon the present value of cash flows after adjustment to income tax rate. The Weighted Average cost of capital (WACC) is considered for discounting cash flows. 1. Implications of Cost of Capital: Equity is 30 percent at tire cost of 20 per cent and debt is 70 per cent and its cost is 17 per cent pre-tax. The overall cost of capital, i.e., Weighted Average Cost of Capital (WACC) would be as follows : WACC - We Ke + Wd Kd (1-T) Where as We Ke Wd Kd and T stand for the proportion of equity capital to total capital employed, cost of equity capital, proportion of debt to total capital employed cost of debt and tax rate respectively. WACC -.30 *.20 +.70 *.85 = 0.06 + 0.0595 = 11.95 say 12 per cent Therefore, all the cash flows should be discounted at the weighted average cost of capital, in order to arrive at present values of all cash flows. In order to find out the net

115 present value of the investment, since it is a techniques of capital budgeting (Investment decision). We assume that the lessor uses Net Present Value (NPV) technique for quoting lease rentals. 2. Implication of Depreciation Allowance : The lessor being owner of the asset entitled to depreciation allowance. As per agreement, the lessor is the de-jure owner of the asset. There is no doubt about the entitlement of depreciation, since it has been already decided by the tax authorities in this respect. Earlier, another allowance known as Investment Allowance was in vogue but it has been replaced by another scheme Investment Deposit Scheme, under section 32 AB of Income Tax Act, 1961. Hence, this illustration assumes that there is no investment allowance scheme applicable to leasing companies. The claim of depreciation as well as the tax shield on account of depreciation is calculated. The tax savings are discounted at 12 per cent in order to arrive at the present value of total depreciation claims (Table 5.6 shows tire overall calculation in this respect). 3. Cash Flow s Now', let us consider the cash flow; both the inflows and outflows, relating to the equipment to be leased out. The primary and significant outflow to a lessor is the purchase price i.e. cost of the equipment Generally, all other outflows are not significant in determining lease rentals in the primary period because whatever lessor incurs such as legal, documentation, brokerage, stamp duty and all other incidental charge are to be bom by the lessee at the time of agreement. 7he outflow to a lessor is the equipment cost which is to be incurred at the beginning of the agreement. In this example, it is assumed that the cash outflow is Rs. 8,00,000 towards the purchase of the equipment. But there is no need to discount the cash outflow since the flow is at the beginning of the agreement. Therefore, the present value of

116 cash outflow towards purchase of equipment is = Rs. 8,00,000. Table 5.6 and 5.7 are self explanatory. TABLE 5.6 Depreciation and P.V. Factor Year Asset Book Depreciation Depreciation PV Factor Post Tax PV Value 331.0% on Tax Shelter at 12%PA of Depreciation (Rs.) WDV @ 50% (Rs.) (Rs.) (a) (b) (c) (d) +(CX 50) (E) (F) = (DXE) 0 8,00,000 1 5,33,333 2,66,667 1,33,334 0,89286 1,19.049 2 3,55,555 1,77,778 88,889 0,79719 70,861 3 2,37,037 1,18,518 59,259 0,71178 42,179 4 1,58,025 79,012 39,506 0,63552 25,107 5 1,05,350 52,675 26,337 0,56743 14,945 6. 70,233 36,117 17,558 0,50663 8,896 7. 46,822 23,411 11,705 0,45235 5,295 8. 31,215* 15,607 7,803 0,40388 3,152 2,89,484 Includes transfer price at one per cent of the equipment cost Rs. (8,00,000*0.01) at the end of the 8th year. Under block assets depreciation scheme, loss on sale is not considered allowed to debt to the profit and loss account, as a loss. Therefore, 8 Dt * T = (1+.12)8 - Rs. 2,89,484 Cash Inflows t= 1 Lease Management Fee (LMF) : Lease management fee in this example is 2 per cent of the cost of the equipment LMF is payable by the lessee to the lessor at the time of signing of the agreement. This is an expense item to the lessee and an income (revenue)

117 item to a lessor. Being a revenue item, LMF is taxable at the hands of lessor at the Income Tax rate applicable. In our example, the LMF is Rs. 16.000 (8,00,000 * 0.02) and due to an account of tax liability the effective (Post- tax) management fee would be Rs. 8,000 (1-0.50). There is no need to discount the LMF since it is received at the time of agreement of the contract. The post-tax LMF can be subtracted in order to arrive at the effective cash outflow at the year O. Therefore, the effective cash outflow' would be as follows : = initial investment-post-tax LMF = Rs. 8,00,000-8000 = Rs. 7,92,000 Hence Rs. 7,92,000 has been considered while calculating the lease rentals in the primary' period and in the later part of the calculation. 4. Secondary Period Lease Rentals As stated earlier, during the secondary' period, lease rentals are nominal. The secondary period was significant when the investment allowance was in force or the depreciation allowance is to be written off'. In order to claim the investment allowance, it is pre-condition that the asset should not be transferred before completion of 8 years. In the period, rentals are very' nominal. The secondary period lease rentals are also income items, therefore taxable. Hence, the present value of secondary' period lease rentals should be adjusted on post-tax basis. The example assumes that lease rentals are Rs. 1,000 per annum from 6th through 8th years on advance basis i.e. at the end of 5th, 6th and 7th or beginning of the 6th, 7th and 8th years. Therefore, the post -tax present value of secondary period lease rentals would be as follows : = 1000 (1-Tt + 1.000 (1-T) + 1.000(1-1) (1+0.12)5 (1+0.12)6 (1+0.12)7 = 500 *0.56743+500 *0.50663 +500 *0.45235

118 = Rs. 284*253*226 = Rs. 763 5. Transfer Price While considering the transfer price, no tax adjustment should be made, because no tax adjustment is considered, But if the transfer price is excess over the book value as on sale date, there arise capital gain tax. which is generally lower than the income tax. In this example, the transfer price is less than the hook value of the equipment. The present value of transfer price can be calculated as follows : Transfer Price = 1 per cent of the equipment cost = Rs. 8,00,000*0.01 = Rs. 8,000 Present value of transfer price would be = 8.000 (1.12)8 = 8,000* 0.40388 = Rs.3,231 in order to determine the primary period lease rentals the present value of transfer price should be subtracted form the equipment cost. 6. Determination of Primary Period Lease Rentals (Break -Even Rentals) The following formula can be used to find out the amount to be recovered during the primary period by the lessor by way of lease rentals 5 LRp n-t) 8 LRs tl-t) Q = E (1+k/ + 2 (1+k) t = l t = 6 8 Dt T TPn E (1+k)8 + (1+k)8 t=l Where, the C is the effective cost of outflow i.e. cost of the equipment less LMF. The first component on the right hand side of the equation is the post-tax present values of lease rentals in the primary' period (to be calculated). The second component stands for the post-tax present value of lease rentals during the secondary period, the third component represents the present value of depreciation allowance through the tax shield at the existing tax rate. The last component stands for the present value of transfer price of the equipment at the end of 8th year

119 (8,00,000-8,000) 7,92,000 5 LRp (1-T) + 763 + 2,89,484 + 3,231 Z (1 +.12)5 t= 1 5 LRp (1-T) + 2,93,478 (1+.J2)5 t = 1 5 LR (1-T) Z (1.12)5-7,92,000-2,93,478 = 4,98,522 1=1 LRp (1-T) Rs. 1,38,298 The lease rentals Rs. 1,45.633 is post-tax, therefore, we need to calculate on pretax basis since the lessor charges on pre-tax basis. Hence, the pre-tax lease rentals would be Post tax lease rentals 1.38,294 = Rs. 2,76,588 (1-T) (1-.50) 2,76,588 The monthly break- even rental will be = 12 = Rs. 23,049 = Therefore, it can be said that Rs.28.80/1,000 per month for thousand. (If we consider the Investment Allowance of 20 percent of the equipment cost, the quarterly break-even rental will be Rs. 24.68/1,000 per month). The lease rentals can be converted into lease rate i.e. for equipment cost of Rs. 1,000 five years, lease period would be Rs. 28.80/1,000 per month. This is break-even rental at the specified conditions. But the lessor should charge higher than the break-even rental in order to meet the expenses like personnel, office and administrative, which ranges from 5 to 10 percent of the total income. The quoting of lease rentals during the primary period is depending upon the number of factors such as cost of capital i.e. discounting factor for cash flows, lease management fee, rate of depreciation allowance, secondary' period lease rentals, transfer

120 price and tax rate. Let us say that quoting lease rentals in the primary period ( LRp) is the function of all the following variables. Lrp = f(k, LMF, Dt,Lrs,T) Among all, the cost of capital plays a key role in determining the rentals in the primary period. There is a direct relationship between the cost of capital and lease rentals in the primary period. Let us assume that the cost of capital i.e. discounting factor declines to 8 percent from 12 percent, as the other factors remain constant, the break-even lease rental would be Rs. 24.60 and the cost of capital still declines, the quotes would be minimised. Similarly, if there is an increase in the cost of capital, i.e. discount factor, the lease quotes will increase accordingly. However, there is an inverse relationship between the lease quotes and LMF. LMF increases, lease quotes decreases and vice versa. Similarly, all other components such as the depreciation, lease rental in the secondary periods and salvage value having direct (positive) correlation to the primary' period lease rentals. This model has been confined to the calculation of yearly rests. A monthly lease rates are obtained by dividing 12. Using the yearly rests as used in this model would in effect imply that the returns to the lessor will be slightly higher in as much as lease rentals are being collected on monthly rests from the lessee which in turn generates to an additional income by the end of 12 months. Another assumption of this model, is that, taxes are paid at the time cash inflows effect. But in practice, it is not prevalent, lease rentals are received by the end of the year 12 times in advance i.e. before the end of the year 12 times, whereas income tax is paid after finalisation of accounts or incase of advance tax, taxes are payable three times during the latter part of the financial year.

121 Another assumption is that all cash inflows are reinvested at the discount factor. In practice, it is not possible at all times. The rental is the key element of lease quotation. But other factors should not be overlooked. Individual cases, the lessor will rate the relative importance of the various financial terms and conditions differently on the basis of lessees requirements. Some will seek a longer lease terms, others will prefer short, some require front end lease, some other will seek back ended leases. But in practice, the rentals quoted by leasing companies are less than the calculated rates in the example. It is because, in practice, leasing companies are not paying 50 percent tax, almost all leasing companies are paying only 30 percent tax on their book profits under Section 115J of Income Tax Act. Therefore, the tax rate 50 percent is not applicable to the leasing companies whereas 50 percent tax rate has been considered for calculation of rentals. On the basis of calculation, let us conclude that determination of lease rental is the function of the cost of capital, depreciation, tax rate, lease management fee, secondary lease period rentals and transfer price of the equipment. TABLE 5.7 DEPRECIATION TAX SHELTER Years Depreciation Discount Factor 8% Present Value of Depreciation Tax Shield 1. 1,33,334 0.92593 1,23,458 2. 88,889 0.85734 76,208 3. 59,259 0.79383 47,042 4. 39,506 0.73503 29,038 5. 26.337 0.68058 17.924 6. 17,558 0.60317 10,590 7. 11,705 0.58349 6,830 8. 7,803 0.54027 4,216 3,15,306

122 Secondary period lease rentals = 500* 0.68058+500*0.60317 + 500* 0.58349 = 340 + 302 + 292 = Rs. 934 Salvage Value = Rs. 8,000 * 0.54027 = Rs. 4,322 7,92,000 = PVLR + PVLR + PV DT + PVSM = PVLR + 934 + 315306 + 4322 PVLR = 7,92,000-3,20,562 = 4,71,438 = 471438 = 118075 * 2 = 2,36,150 pre - lax 3,99,271 pre- tax per month = 19,679 = Rs. 24.60 If vve consider the investment allowance at 20 percent, the break- even rental would be Rs.20.87/1,000 per month D) EVALUATION OF LEASES BY LESSEES The main feature of finance lease is that it transfers all risks and rewards associated which the ownership of an equipment from the lessor to the lessee. Finance lease may be considered as one of the alternatives of acquisition of an asset. Lessee may consider leasing and buying as two mutually exclusive ways of investing in asset. However, in finance theory, the investment decision is precedes the financing decision. There has been extensive discussion and controversy on the subject whether leasing a financing decision or an investment decision or both. Tom dark quoted in his Handbook on Leasing that if a firm is deciding between leasing and borrowing it is purely a financing decision. If a firm is deciding between leasing and buying. It is a combination of both investment and financing decisions. The cost of leasing to a lessee and lessor is dependent upon various factors such as income tax, investment incentives / allowances (Investment allowance, depreciation,

etc.) cost of capital, marginal cost of capital, lease terms, structure of lease rentals etc. If the corporate tax rates are higher to a lessee, the greater the advantage it can avail by purchasing the asset and obtaining the tax benefits of depreciation and interest payment. If the written down value (accelerated) deprecation is used instead of straight line method then the tax advantage would be concentrated on immediately after the acquisition of asset. This would reduce the net cost of owning in the early years but raise it later on. The overall impact on the present value of borrowing may be reduced sufficient to make it more profitable than the lease financing. Owners of the assets are allowed to deduct certain proportion of their asset value for tax purposes as investment allowance tax credit provided the assets are new..an exemption under investment allowance adds to the benefit of owning the asset. Although part of benefits may be passed to the lessee in the form of reduced rentals in the course of the competitive process. It would end to favour purchase rather than leasing. The financial costs and charges relate to the cost and maturity of the contract. While non- financial costs include the cost of acquisition, maintenance and cost of disposal of an asset. Similarly, a higher salvage value would reduce the relative advantage of leasing as compared to owning. As regards higher salvage value, lessors would ensure that the benefits of higher salvage value will partially be passed on to lessees in the fonn of reduced rentals..an attempt is made to study and analyse the evaluation techniques of leases by the lessee. As one follows with evaluation of capital investments, the project is financed by a mix of debt and equity reflecting the capital structure of the firm. To consider an equipment acquisition through lease, the analysis must be expanded to consider lease financing option in addition to the conventional debt financing option. While mere are many different evaluative methods in use. those of primarily interest fall into the Discounted Cash Flow (DCF) methodology. The Net Present Value (NPV), Internal Rate Return (1RR) are commonly used methods under DCF

124 methodology. Net Present Value (NPV) discounting all expected after tax cash flows to present value and then taking the difference between the present value of inflows and present value of outflows. The difference is called the Net Present Value (NPV). This method requires the use of a discount rate, which the management must determine on the basis of its costs of capital and degree of risk involved in the project being evaluated visa- vis the risk attached to the firms current composite portfolio of project. The Internal Rate of Return (IRR) method is similar to net present value. However, rather than determining the net present value using a predetermined discount rate, the goal is to find out the discount rate which equates the present values of inflows and outflows of project. When applied to the after tax cash inflows and outflows, well result is a net present value of zero. In other words, IRR of a project is the discount rate which makes its net present value equal to zero. In the net present value calculation, We use discount rate which is known to us and in IRR we arrive IRR by making present value of inflows and outflows equal. The discount rate is called the internal rate of return (IRR). There is a lot of controversy across world over which method should he used to evaluate future cash flow. What rate is to be used to discount the cash flows of the lessee. Is cost of debt be used? Is the weighted cost of capital be used? Is the marginal cost of capital be used? There are three different present value discount rates employed in the lease analysis depending on which particular step in decision model is being used. After tax incremental borrowing rate represents the interest rate of a bank or financial distribution would change currently or incrementally for a loan similar to a loan in amount, terms and risk, if the company does not use bank/financial cost, leasing borrowing, or after forms of debt should be used. The borrowing rate which is multiplied by one minimum the firms eff ective tax rate

125 (1-t) to adjust for tax deductibility of interest expense occurred debt to acquire equipment. Investmental after tax weighted average cost of capital and the weighted average of company s cost of debt and equity. The cost of capital is calculated by using the following formula. Cost of capital = Ke E + Kd D (D+E) (D+E) Where Ke = cost of equity = D1 + G Po D1 = expected annual dividend next year Po = Stock price at the present time o Co = expected growth rate in earnings per share Kd = incremental after tax cost of debt i = (1-t) i = incremental cost of debt t = incremental effective tax rale E = current market value of the firms equity stock D - current market value of the firm s debt Risk adjusted cost of capital is calculated by adding to the incremental after tax weighted average cost of capital as calculated above plus a risk premium. The risk premium will take the form of additional percentage added to the cost of capital percentage discount rate to compensate for leases in which the risk of the asset acquisition is perceived to be above average. CHART - 5.1 T he Chart 5.1 illustrates I_xa.se decision making

126 There are two alternative methods to evaluating the relative costs of benefits of a lease which provide answers to each of two different questions. Net Present Value (NPV) approach and Equivalent Loan (Implicit interest rate) approach. These two methods are discussed with an illustration. I^ease purchase decision is a financing decision, separate and district from an investment decision. The Chat! 5.1 diagram provides the base from which the analysis is derived. The investment decision to acquire or not to acquire an asset precedes and distinguishes from financing decision (how to pay for the asset) Leasing is a form of debt. Therefore, the lease / buy analysis performed after the investment analysis is done and compares the leasing to alternative forms of debt. The point of view is that leasing is a financing decision can be reinforced by a logic that in essence. The determination of whether the services of a particular asset should be acquired requires evaluation of both investment and financing considerations. The investment side of the picture focuses on whether the benefits associated with the asset exceeds its cost of ownership, operation and financing, the financing dimension addresses how the services of asset can be obtained in the least costly way. The financing evaluation model assumes that the firm has gone through a prior decision to evaluate the acquisition of the asset i.e. to acquire the asset. The asset is required for firm s operations. Under such conditions, the firm must decide upon the most favorable financing arrangement. Purchase for cash, borrow and buy or enter into one of the possible leasing contracts. The investment and financing evaluations model simultaneously both at the attractiveness of the asset and financing of the asset. The major difference between the financing evaluation model and the investment and financial evaluation model is that the latter must consider the benefits that will result from the investment as well as operating

127 and financial costs associated with various financing alternatives. Let us consider that ABC company decided to acquire an asset whose cost is Rs. 8,00,000 and consider to acquire one of the feasible financing options. As discussed earlier the cash inflows of a lessor (Leasing Company) will become the cash outflows of lessees. Therefore, all + signs will be replaced by 4 sign and vice-versa. However, the discount rate to be used for a lessee differs from that of a leasing company. In Chart 5.1, we considered weighted average cost of capital at 12 per cent and tax rate i.e. 50 percent. These two factors i.e., cost of capital and tax rates are different from that of lessor. The lessee uses cost of borrowing i.e. cost of debt since leasing is a substitute to alternative forms of financing. The tax rate differs from lessee to lessee and from time to time. Let us consider an example to understand the impact of net advantage of leasing depending on the lessees, tax rate as well as borrowing rate. Lease Assumptions : Net Present Value Approach Asset cost = Rs. 1,000 Primary lease period = Three annual rental in arrears of Rs. 400 each. Secondary lease period = Five annual rentals in arrears of Rs. 4 each. Leases Tax rate = (a) Zero tax rate (b) 50 per cent tax rate Leases borrowing rate = (a) 16 per cent (b) 20 per cent The present value of leasing option can be considered in case of Non- tax paying lessee with (a) 16 per cent and 20 per cent borrowing rates.

128 TABLE 5.8 ZERO TAX PAYING LESSEE Year Less Rental (Rs.) Discount Factor at 16% and 20% Present Value (Rs.) at 16% and 20% 1. 400 0.862 0.833 345.0 333.2 2. 400 0.743 0.694 297.0 277.6 3. 400 0.641 0.579 256.0 211.6 4. 4 0.552 0.482 2.2 1.9 5. 4 0.476 0.402 1.9 1.6 6. 4 0.410 0.335 1.6 1.3 7. 4 0.354 0.279 1.4 0.9 8. 4 1220 0.305 0.194 1.2 0.7 Aggregate Present Value of rents 906.3 818.8 Cost of asset 1000.0 1000.0 NPV = gain from leasing 93.7 181.2 The Table 5.8 evaluates the non-tax paying lessee with a borrowing rates of (16 per cent and) 20 per cent respectively using the Net Present Value (NPV) approach. The asset cost is greater than the present value of the rentals using the lessee s assumed borrowing rates of 16 per cent and 20 per cent annum and leasing is a attractive proposition. Let us Look it differently, this lessee could borrow Rs. 906.3 at 16 per cent and Rs. 818.at 20 per cent to provide fund for acquisition out of which it could pay the annual rentals as well as interest on the reducing balance of loan. The lessee would then be at Rs. 93.7 and Rs. 181.2 better of than if he had bought the asset and thus borrowed Rs. 3000. 1. Tax Paying Lessee The Table 5.9 evaluates the same lease proposal under Net Prevent Value method with borrowing rates of 16 per cent and 20 per cent with a tax rate of 50 per cent under both of the interest rates.

129 TABLE 5.9 50 PERCENT TAX PAYING LESSEE Year Lease Rental (in Rs.) Discount Factor Cost 50% Tax Rate (a) 16(1-.50%) 8% (b) 20(1-0.50)=10% Present Values (inrs.) at 8% at 10% 1. 400 0.926 0.909 370.4 363.6 2. 400 0.857 0.826 322.8 332.4 3. 400 0.794 0.751 317.6 300.4 4. 4 0.735 0.683 2.9 2.7 5. 4 0.681 0.621 2.7 2.5 6. 4 0.630 0.564 2.5 2.3 7. 4 0.583 0.513 2.3 1.9 8. 4 0.540 0.467 2.1 3 124 3 Present value of lease rental 1,023.3 1,009.9 Cost of the equipment 1.000.0 1.000.0 (23.3) (9.9) The NPV is negative at 16% and 20% interest rates which means that leasing on the terms offered costs more than purchase using a source of funds costing 16 per cent and 20 per cent per annum. In this case, the lessee would have had to borrow Rs. 1,023-30 at 16 per cent and Rs. 1,009.90 at 20 per cent as in the case may be per annum to discharge the taking into account the related tax effects. Clearly, the lessee would be better of borrowing Rs. 1,000 to buy the asset The net advantage of leasing means the incremental advantage over the net present value of buying the asset through conventional financing. A positive net advantage of leasing implies that leasing has an advantage over the net present value of asset as an investment Positive present value means positive returns to investing in the asset. A positive net advantage of leasing implies advantages to leasing. It is considered that leasing may convert/sum a financially viable asset into financially viable investment For example, the NPV of asset is negative Rs. 10,000 and the lessor offers it under a lease term that have

130 a positive net advantage to the buyer (iessee)say Rs. 25,000. Then he can acquire the asset by leasing. The buyer (lessee) gains a net of Rs. 15,000 (20,000-10,000). The following decision rules may be used to decide whether (a) to purchase the equipment. (b) to lease the equipment, or (c) to reject the proposal of investment. (1) If NPV of investment is positive investment in the project (2) If NPV of purchase is positive and also greater than NPV of leasing, purchase the asset (3) If NPV of leasing is positive and also greater than NPV of purchase, lease the asset (4) If NPV of purchase as well as NPV of leasing are negative, reject the proposal. (5) If NPV of purchase is negative and NPV of leasing i.e. net advantage of leasing is positive, lease the equipment i.e. lease if sum of NPV and net advantage of leasing is positive. 2. Equivalent Loan Method The equivalent loan method assumes two fundamental assumptions : (1) decision to acquire the asset has been already made, and (2) the asset, if purchased, will be debt financed, the first assumption is necessary for considering the leasing as a financing alternative. The second assumption is necessary to evaluate lease replaces the debt As discussed earlier, the lease purchase decision is a financing decision separate and distinct from investment decision. The investment decision i.e. to acquire or not to acquire an asset precedes and distinct from the financing decision i.e., how to pay for the asset and leasing is a form of debt. Therefore, the lease Vs buy advantage is performed after the investment analysis and compares the leasing alternative to other forms of debt mainly bank borrowing. Lease purchase decision is a financing decision, separate and distinct from the

131 investment decision. The investment decision to acquire or not to acquire an asset precedes and is distinct from the financing decision i.e. to pay for the asset The lessee sets down the incremental cash flows arising from a decision to lease than to buy and then work out the discount rate which will give a total present value for all those receipts and payments equal to nil. In other words, the present value of the rentals at that discount rate equals the cost of the asset. The incremental cash flows are all those cash flows which arise solely from the decision to lease rather than to buy thus they include the savings of purchase price and the rental payments. Table 5.10 evaluate the non-tax paying lessee under Equivalent Loan or Equivalent Interest Rate approach. TABLE 5.10 NON- TAX PAYING LESSEE Year Cost of Asset Saved in (Rs.) Rental Paid Discount Factor at 9.7% Present Value in Rs. 0 1,000 1,000 1,000 1 400 0,912 (365) 2 400 0,831 (332) 3 400 0,757 (303) 1,000 1,200 Nil What is important of this discount factor or equivalent interest rate of 9.7 per cent per annum. It is clear that lessee could borrow money to buy the asset using a loan at a rate of 9.7 percent per annum with repayment Rs.400 per annum for three years, it would be indifferent between buying using this loan or leasing on three annual rentals of Rs.400 each for the same asset If same lease had been undertaken by a tax paying lessee, then the

132 incremental cash flows would have been different than that of the example discussed in Table 5.7. It is seen from the above discussion, leasing is less attractive proposition to the taxpaying lessee than the non-tax paying lessee. Similarly, leasing is more attractive proposition to the lessees with higher borrowing rates compared to companies which have access to funds with lower borrowing rates. The net advantage of leasing derives basically two major sources such as differential tax rates and cost of capital of lessees and lessors. The leasing success depends on the spread between cost of capital make leasing as an attractive and viable mode of acquisition of asset. In addition to the financial considerations i.e. tax rate and borrowing rate, there are several other considerations which may be relevant in evaluating leasing decisions : (a) borrowing capacity of the lessee firms: (b) time factor for getting loan and arranging leasing proposals: (c) cash flows sequences lease rentals as well as loan repayment schedules, (d) obsolescence risk etc. 3. Sensitivity Analysis A potential lessee comparing borrowing and leasing alternative will generally recognise various uncertainties in the factors which effect the comparison. These may for example, relate to the prospects of changes in marginal borrowing costs the period effected by the lease or doubts as to when the lessee may more into a tax paying situation. The best approach to these uncertainties is to compute alternative assumptions under NPV or Equivalent Loan Method of evaluation. The results indicate the sensitivity of the NPV likely changes in the particular parameters and will enable the lessee to make judgement about the most favorable financing option. Besides, the adjustments in terms of monthly, quarterly interest rests and discounts calculations are often used. These methods of

133 evaluation were also extended to incorporate other variables including stepped lease rental, uneven lease rentals, front ended lease rentals, and other variable terms and conditions. Dr. Raghunath criticised the approach used by Pandey and outlined a better approach to lease evaluation that envisages a useful economic role for leasing, and commented on the Indian leasing scene. The myths and realities about leasing narrated by Pandey in his article are misleading and Raghunath has commented on these myths under the heading More on the Myths and Realities about Leasing. E) BETTER APPROACH TO LEASE EVALUATION Pandey uses the same discount rate for both lessor and lessee, namely the going rate of interest for long term funds in the market This approach provides no economic role to leasing other than as a market for trading in tax shields, resulting in a joint minimization by lessor and lessee of their tax. In this approach, leasing has no role to play when both lessee and lessor profit by the transaction. If both profit and absorb their respective tax shields in the period in which they accrue, both will have the same discount rate, namely the after-tax interest rate (say r (1-T), where r is the interest rate and T is the corporate tax rate), Also cashflows for the two are identical except that inflow for one is outflow for tire other and vice versa. In this approach, therefore, leasing has no internal economic justification since the lessor is always assumed to be loss making, which is the raison d etre for a lease deal to be acceptable to both, such a position is untenable simply because no activity which presupposes losses is worth undertaking in the first place. What should then be the correct approach to lease evaluation? To answer this question, it is necessary to take a closer look at the differences in the perspectives of the lessee and lessor to lease evaluation.

134 1 Lessee s Perspective Let us assume that a profitable firm is considering the acquisition of a capital asset. Assuming that the objective of the firm is to maximize wealth for its shareholders, its decision making process may be viewed as follows : If the present value of the net operating cash flows (accruing from the deployment of the asset) when discounted at the overall cost of capital of the firm (in order to ensure maximization of wealth to its shareholders) exceeds the investment, the asset would be acquired or else it would be rejected. Such a decision process is said to be based on the net present value (NPV) criterion. The asset may be acquired by the firm either by outright purchase or by leasing. The two options may be viewed as two mutually exclusive projects of which only one can be accepted. The problem then simply reduces to ranking the two alternatives in terms of their NVPs and selecting the alternative with a higher NVP. (a) Purchase Option When the asset is purchased by the firm outright, there is typically a large cash outflow by way of the acquisition cost of the asset, followed by a stream of operating cash inflows which are taxed. Further the firm receives tax shield on depreciation (and investment allowance if applicable ). Finally, the salvage value of the asset accrues to the firm with an appropriate terminal depreciation or a balancing charges as the case may be. Thus, the asset may be purchased if n Xfl1_-T) NPVp = A + 2 (1+K)1 i = I n DiT S > 0 + 2 (1+ K)' + (1+ K)n (1) i = 1

135 Where A Xi T Di S K = acquisition cost of the asset = net operating earning at the end of period i = income tax rate (percent) = depreciation amount at the end of period i = post- tax salvage value, adjusted for terminal depreciation or balancing charge = weighted average cost of capital of the firm, which is discussed in greater detail later. ( Note : The investment allowance term may be introduced if necessary) 1 It is assumed that the deployment of the asset does not charge the risk class of the firm. (b) Lease Option In case the asset is acquired through a lease, there might typically be a small down payment as advance rental, followed by a stream of further rental payments on the one hand and receipt of the stream of operating cash inflows on the other. The lease rentals are taxed. Further the operating cash inflows in this case would be identical to those under the buy option, assuming that the maintenance and other related costs of the asset are borne by the firm under both options. Thus, the asset may be leased if: n-1 L n LT NPV 1 = -L Z (1+ K)' + S ( 1+ K)j i = 1 i= 1 n Xt(I--T) + s >0 + L (1+K)' ( 1+ K)n i = 1 Where L = equalized lease rentals { 0, if the asset reverts to the lessor, and S = { S - b, if by paying a nominal amount b to the lessor, die firm can { somehow acquire possession of the asset which is worth S.2 In equation (2), the advance payment of lease rentals has been stressed, so that the advance rental may be visualized, as the initial investment. Further, the L and LT terms axe separated to highlight