Lease Evaluation From Lessee Angle

LEASE EVALUATION : LESSEE ANGLE 1) FINANCIAL EVALUATION 2) EVALUATION OF NON FINACIAL FACTORS 3) EVALUATION OF LESSOR

FINANCIAL EVALUATION: THREE MODELS

WEINGARTNER’S MODEL • Calculate NPV of lease alternative NPV (L) • Calculate NPV of buy alternative NPV (B) • Compare both – If NPV (L) > NPV (B) > 0 • GO FOR LEASE

• Discount rate (k) will be marginal cost of capital

• k = D D+ E

k D* ( 1 – T ) +

E

* kE

D+E

• Where – KD & KE is marginal cost of debt & equity – D:E is Debt – Equity mix in target capital structure – T is tax rate

EQUIVALENT LOAN MODEL /BOWER MODEL / BHW MODEL • Weingartener's model & BHW model uses marginal cost of capital as discounting factor • Equivalent model uses pre tax marginal cost of debt as discounting factor • Bowers model leaves it at decision of decision maker

ICMR SUGGESTS • Lease rental • • • • •

At pre tax cost of debt ( k D )

Tax shield on lease rental At marginal Tax shield on Management fees cost of Tax shield on depreciation capital ( k ) Tax shield on interest Residual value

NET ADVANTAGE OF LEASING • NAL =

Investment cost - PV of lease payment

+ PV of tax shield on lease payment - Management fees

+ PV of tax shield on management fees - PV of Tax shield of depreciation - PV of tax shield of interest - PV of residual value

PRACTICAL PROBLEM • Initial outflow

10 lacs

• Inflows

2 4 6

1 yr 2 yr 3 yr

• If the cost of fund is 12 % P A , should the company go for the project ?

SOLUTION • Yr 1 2 3

cash flow 2 4 6

PV 2 * PVIF(12,1) = 4 * PVIF (12,2) = 6 * PVIF (12,3) =

1.79 3.19 4.27

• Where PVIF is present value interest factor for given values if “i” & “n” • Total PV of inflows is 9.25 lacs which is lesser than investment & hence project should not be accepted • If the cash flows & time interval both are equal then we use PVIFA i.e. Present value Interest factor annuity

PRACTICAL PROBLEM • A loan of 100000/- is to be paid in 5 equated annual installments .if it carries an interest of 14 % PA , find out installment ? • SOLUTION • EMI * PVIFA (14,5) = 100000 • EMI = 100000 / 3.433 = 29129 • YR EMI INTT PRINCIPLE LOAN O/S 0 100000 1 29129 14000 15129 84871 2 29129 11882 17247 67624 3 29129 9467 19662 47962 4 29129 6715 22414 25548 5 29129 3577 25548 -

PRACTICAL PROBLEM • A loan of 100000/- is to be paid in 5 equal annual installments .if it carries an interest of 14 % PA , find out installment • SOLUTION • YR INTT PRINCIPLE INSTALL 1 2 3 4 5

14000 11200 8400 5600 2800

20000 20000 20000 20000 20000

34000 31200 28400 25600 22800

LOAN O/S 80000 60000 40000 20000 -

PRACTICAL PROBLEM • A loan of 100000/- is to be paid in 5 equal annual installments .if it carries an interest of 14 % FLAT , find out installment • • • • •

SOLUTION 100000 * 14 % = 14000 14000* 5 = 70000 EMI = 170000 / 5 = 34000 YR INSTALL INTT PRINCIPLE LOAN O/S 1 34000 14000 20000 80000 2 34000 14000 20000 60000 • 34000 * PVIFA ( i , 5 ) = 100000 • Effective “i” or annual % rate “APR” = 20 % • On monthly or daily reducing it would be much higher than that

CONCEPT • Lease rental are either paid in advance or in arrear • All payment at intervals less than a year are called “annuity payable pthly” where p is frequency during the year • P is 12 if annuity is monthly or 4 if it is quarterly • So PV of annuity payable pthly in arrear = PVIFA p ( i , n) = i PVIFA ( i, n ) i (p) • So PV of annuity payable pthly in advance = PVIF A p ( i , n) = i PVIFA ( i, n ) d (p)

PRACTICAL PROBLEM • Calculate PV of lease payments if marginal cost of debt is 20 % A) Lease term is 3 years & LR is 36 ptpm payable in arrear B) Lease term is 5 years & LR is 25 ptpm payable in advance • SOLUTION 36 * 12 * PVIFA 12(20,3) 432 * i

* PVIFA (20,3 )

i (12) 432 * 1.0887 * 2.106 = 991

CONTD. • B) 25 * 12 * PVIF A 12 ( 20,3 ) 300 * i

PVIFA ( i, n )

d (p) 300 * 1.105 * 2.991 = 992

PRACTICAL PROBLEM • • • • • • • •

Investment cost Rate of depreciation Useful life Salvage value Cost of debt (comparable to lease ) Cost of capital Tax rate is Lease option (payable annually in arrears)

60 lacs 40 % 4 years 5 lacs 17% 12% 46% 444/1000

• Compute NAL if net salvage value is 6 lacs after 3 years

SOLUTION • Initial investment 60 lacs • PV of lease rental 60 * 444 / 1000 * PVIFA(17 ,3 ) = 26.64 * 2.210 = 58.87 lacs • PV of tax shield on = (60 * 444 /1000 )* PVIFA(12,3) * 0.46 lease rentals = 29.44 lacs • PV of tax shield on = [24 * PVIF (12,1) + 14.4 * PVIF(12,2) + depreciation 8.64 * PVIF (12, 3)] * 0.46 = 17.96 lacs • PV of interest tax =[10.01 *PVIF (12,1) +7.18 * PVIF(12,2) shield ( on + 3.87 * PVIF (12,3)] * 0.46 displaced debt ) = 8.01 lacs

SOLUTION contd. • PV of net salvage value = 6 * PVIF ( 12, 3) = 4.27 lacs • NAL = 60 - 58.87 + 29.44 - 17.96 – 8.01 – 4.27 = 0.33 lacs • NAL is positive & it is economically viable • ( DISPLACED ) DEBT AMORTISATION SCHEDULE YEAR 1 2 3

LOAN O/S 58.87 52.24 22.78

INTT 10.01 7.18 3.87

PRINCIPAL 16.63 19.46 22.78

RENTAL 26.64 26.64 26.65

PRACTICAL PROBLEM • Considering data of previous question assume LR is 35/1000 payable monthly in advance , calculate the NAL of leasing • Only following would change • PV of lease rentals = (60 * 35/1000 * 12 ) * PVIFA p (17,3) = 25.2 * i * PVIFA (17, 3) d(12) = 25.2 * 1.09 * 2.210 =60.70 lacs • PV on tax shield of = [ 60* 35/1000 *12 * PVIFA(12,3) * 0.46] lease payments = 27.84 lacs

SOLUTION contd. • PV on interest tax shield = [8.05 * PVIF (12, 1) + 5.13 * PVIF on displaced debt (12,2) + 1.72 * PVIF (12,3) ] * 0.46 = 5.75 lacs • ( DISPLACED ) DEBT AMORTISATION SCHEDULE YEAR LOAN O/S INTT PRINCIPAL RENTAL 1 60.70 8.05 17.15 25.2 2 43.55 5.13 20.07 25.2 3 23.48 1.72 23.48 25.2 • There would be no change in PV of salvage value & PV of tax shield on depreciation • NAL = 60 – 60.70 + 27.84 – 17.96 – 5.75 - 4.27 = ( - ) 0.84 • NAL is negative ,hence lease is disadvantageous

INTEREST CALCULATION ON DEBT AMORTISATION SCHEDULE

• • • •

25.2 *1.09 60.70 *17 % 27.46 – 25.2 10.319 – 2.26

= 27.46 = 10.319 = 2.26 = 8.05

LEASE EVALUATION PRACTICE IN INDIA • 100 % financing • Simple documentation • Expeditious sanction • No financial covenants in lease agreement • No detailed post sanction reporting • Flexibility in LR • Off B/S feature of finance (maintains borrow capacity of firm )

EVALUATION OF LESSOR BY LESSEE • In large leveraged lease, lessor is minor equity participant • Lessee has to deal with lessor & financier both which has operational difficulties • So lessee looks following in audited B/S of lessor – – – – – – – –

Profitability Risk of deviation of ROE with average Coefficient of variation of ROE in inter lessor comparison Annual growth rate in investment in capital assets , profit , capital employed His credit rating if any Ability to tap financial resources on ongoing basis His experience Whether lessor is his one stop shop for all finances