Lease Evaluation From Lessor Angle

LEASE EVALUATION FROM LESSOR’S ANGLE

INTRODUCTION • Computation of break even – Minimum LR from lessor’s angle which he can accept – Minimum LR at which NAL from lessor’s point is zero – Sets the floor price of lease

• Gross yield & pricing of lease • IRR method of calculating lease • Lease related risk , assessment of credit risk, product risk & methods of risk management

CASH FLOW STREAM • • • • •

Constituent lessor lessee Initial investment outflow inflow Management fees inflow outflow Direct cost outflow -----LR inflow outflow

• IT liability on LR outflow ( tax shield)

inflow

• Tax shield on foregone depreciationinflow

outflow

• Sales tax on LR

-----

• Residual value

inflow forgone

outflow inflow

PRACTICAL PROBLEM • • • • • • • • •

Cost of equipment 33 lacs (inc ST@ 10 %) Salvage after 5 yr 10 % of cost Initial direct cost 0.3 lac ( front ended) Management fees 0.5 lac ( front ended) Cost of funds 14% Tax rate 46% Depreciation 25% Five years lease with rental payable annually in arrears Calculate Break even rental for 25 % depreciation

SOLUTION • • • • • • • • • • • •

Equipment cost 33 lacs PV of LR L * PVIFA (14 , 5 ) = 3.433 L PV of Tax on LR 3.433 L * 0.46 = 1.579 L PV of tax shield on depreciation [8.25 * PVIF (14,1) + 6.19 *PVIF (14 ,2) + 4.64 PVIF (14,3) +2.85 (PVIF (14 ,4 ) + 1.71 PVIF (14,5)] * 0.46 = 8.53 lacs PV of direct cost 0.30 lacs PV of Management Fees 0.50 lacs PV of tax shield on D.C 0.30 * PVIF (14,1) * 0.46 = 0.12 lacs PV of tax shield on M.F 0.50 * PVIF (14,1) * 0.46 = 0.20 lacs PV of salvage value 3.3 * PVIF (14,5) = 1.71 lacs -33 + 3.433 L -1.579 L + 8.53- 0.30 + 0.50 + 0.12 -0.2 +1.71 = 0 L = 12.21 lacs If rate of depreciation is more then Break even will come down

PRACTICAL PROBLEM OF BREAK EVEN

• • • • • •

Cost of equipment 1000 Salvage after 3 yr 8 % of cost Cost of funds 14% Tax rate 46% Depreciation 40% Three years lease with rental payable monthly in advance • Calculate Break even rental

SOLUTION • Equipment cost 1000 • PV of LR 12 L * PVIF A p (14 , 3 )= =12 L * 1 / d 12 * PVIFA (14,3) =12 L * 1.0743 * 2.322 = 29.93 L • PV of Tax on LR = 12 L * PVIFA (14,3) * 0.46 = 12.82L • PV of tax shield on [400* PVIF (14,1)+ 240 * PVIF depreciation (14,2) +144 * PVIF (14,3) ] * 0.46 = 290.98 • PV of salvage value 1000* 0.08 * PVIF (14,3) = 54 • -1000 + 29.93 L -12.82L + 290.98+ 54= 0 • L = 38.28 ptpm • If rate of depreciation is 100% • then PV of tax shield of depreciation would be 877 & Break even will be 4.03 ptpm

ASSESSMENT OF LEASE RELATED RISKS 1.

default / credit risk • Risk of not receiving rentals on schedule • Most significant 1. Residual value risk • Decline in residual value of leased equipment • Full pay out lease can be done

1. Interest rate risk • •

Change on market rate of interest affecting cost of funds Revision of LR on happening of event

1. Purchasing power risk • •

Reduction in value of LR due to inflation Escalation clause can be added in lease agreement

ASSESSMENT OF LEASE RELATED RISKS 5.

Political risk – Change in government fiscal policy viz depreciation or Tax rates – Add clause for revision of LR

5.

Currency & cross border risk – Fluctuation in exchange rate – Hedging can be done

DEFAULT / CREDIT RISK

DETERMINANTS OF CREDITWORTHINESS • Character – Integrity, honesty commitment – From informal reports • Capacity – DE ratio – Interest coverage ratio – Cash flow coverage ratio – Whether lessee is using creative accounting techniques to manage depreciation , valuation of inventories , accounting for leases , accounting for foreign currency translation ,disclosure of prior period, contingent liabilities & extraordinary items to dress up Financial statements

DETERMINANTS OF CREDITWORTHINESS • Conditions & competition – Impact of economic conditions on business of lessee & the competition he is facing

• Collateral – Value maintained by the leased equipment

APPROACHES TO CREDIT RATING •

Explicit judgmental approach – Define set of factors for credit rating & assign weights • Net worth 40 • Current ratio 35 • Profitability 25 – Give scores on 0 -1 scale to lessee • Net worth 0.6 • Current ratio 0.8 • Profitability 0.5 – Obtain overall scores • Net worth 40 * 0.6 = 24 • Current ratio 35 * 0.8 = 28 • Profitability 25 * 0.5 = 12.5

64.5

APPROACHES TO CREDIT RATING •

Statistical approach –

Statistical methods in selection of factors like factor analysis

–

Discriminant analysis for distinguishing between good & bad lessee

INCORPORATING CREDIT RISK IN LEASE AGREEMENT • Increasing LR • Altering payment schedule – More front ended pattern of payment • Reducing duration – Lease term can be reduced • Collecting a security deposit – Forfeit in case of default • Insisting personal & bank guarantee • Residual value insurance

GROSS YIELD • It is defined as compounded rate of return that equates sum of PV of LR & PV of residual value with Investment cost • PV of LR + =

PV of residual value + Management fees

Investment cost + Initial direct cost

• Tax element is not factored • Hence gross yield (pre tax) is compared with cost of funds (pre tax) • In practice, cut off rate is pre tax cost of funds plus a profit margin

PRACTICAL PROBLEM OF GROSS YIELD •

A company has developed the following table for default risk classification on basis of gross yield risk class required yield A 19 % B 21% C 24% D 25% Proposal in hand lease term 5 years LR 25 ptpm in advance 1) Credit rating reveals that lessee can be placed in ‘B’, can this proposal be accepted? 2) Assume if 3 months LR is taken in advance & out of which 2 months would be adjusted against payment due for last two months of lease term, will the answer be different?

SOLUTION part 1 • • • • • • •

25 * 12 * PVIFA p (i,5) = 1000 300 * i / d 12 * PVIFA (i,5) = 1000 i / d 12 * PVIFA (i,5) = 3.333 At i = 0.18, LHS of equation = 1.095 * 3.127 = 3.424 At i = 0.20, LHS of equation = 1.105 * 2.991 = 3.305 Interpolating in range (18,20) we get i = 0.18 + 0.02 * 3.333 – 3.424 3.305 – 3.424

• = 0.18 + 0.02 * 0.091 0.119 • 0.1953 or 19.53 % • Manager should not accept proposal as in risk class B required rate of gross yield is 21 %

SOLUTION part 2 • • • • • • • • •

(25 * 2) + [25 * 12 * PVIFA p ( i , 4.833) ] = 1000 4.833 years = 58 months PVIFA p ( i , 4.833) = 950 / 300 = 3.167 At i= 0.20 1.105 * 2.928 = 3.235 At i= 0.22 1.115 * 2..807 = 3.130 Interpolating in range (20,22) we get i = 0.20 + 0.02 * 3.167 – 3.235 3.130 – 3.235 i = 0.20 + 0.02 * 0.068 0.105 21.29 % , we can accept as gross yield is higher than required yield for B class

ADD ON YEILD • Calculate add on yield of previous question 1000 • Initial investment = • Aggregate LR paid during the period (25 * 60)= 1500 500 • Aggregate interest charge = over the period 100 • Average annual interest charge = ( 500 / 5 ) = 10 % • Add on yield ( 100 / 1000 * 100) • This measure of yield provides a distorted picture of true cost of lease to lessee ( 19.53 % compared to 10 %)

GROSS YIELD BASED PRICING • IFSL uses gross yield price approach at pre tax cost of funds plus 1.3 %.Incremental cost of debt & cost of equity is 15 & 21 %.Gearing ratio is 4 : 1Tax rate is 51.75%.For a lease term of 5 years company collects 1 % management fees upfront & spend 0.5 % of investment as indirect cost upfront & 5% as residual cost after 5 years • Calculate marginal cost of capital • Calculate annual LR collected annually in arrears • Assuming step up pattern by 10 % P.A calculate LR annually in arrears • Calculate LR monthly payable in advance • Deferred payment where no LR for 12 months & then monthly in advance

SOLUTION part a & b • a) • Marginal cost of equity ( 1- 0.5175) • Marginal cost of capital • Required gross yield • • • • •

21 %

=

43.5 %

[4/5 *0.15 + 1/5 *0.435] 20.70 % + 1.3 % = 22 %

b) 10 + L * PVIFA (22,5) + 50 * PVIF(22,5) 10 + 2.864 L + (50 * 0.370) = 1005 2.864 L = 976.5 L = 341

=

1000 + 5

SOLUTION part b& c • b) • [ L * PVIF(22,1) + 1.1 L PVIF (22,2) + (1.1)2 L *PVIF(22,3) + (1.1)3 L *PVIF(22,4) + (1.1)4 L *PVIF(22,5) + 10 + 50 * PVIF (22,5)] = 1000 + 5 = 976.50 • 3.368 L 290 to be charged in first year • L = • • • • •

c) 12L * PVIFA p ( 22,5) + 10 + 50 * PVIF(22,5) = 1000 + 5 38.320L + 10 + 18.5 = 1005 L = 976.5 / 38.320 L = 25.48 ptpm

SOLUTION part d • d) • 12L * PVIFA p ( 22,4) * PVIF(22,1) + 10 + 50 * PVIF(22,5) = 1000 + 5 • 10 + 27.363 L + 18.5 = 1005 • 27.363 L = 976.5 • L = 35.69 ptpm

IRR OF A LEASE • Some companies evaluate lease using criterion of IRR • It is that rate of interest at which the NAL is zero • Lease accepted only of IRR > marginal cost of capital

PRACTICAL PROBLEM OF IRR • • • • • • • •

Target debt equity ratio Cost of debt Cost of equity Tax Depreciation Net salvage value Find IRR for lease proposal Should it be accepted

4:1 18% 24% 46% 40% ignore

SOLUTION • 4/5 * 0.18 * 0.54 + 1/5 * 0.24 • Equipment cost • PV of LR • •

• •

=

12.58%

1000 25 * 12 * PVIFA p (i , 5 ) 300 * i /d 12 * PVIFA (i , 5 ) PV of Tax on LR 25 * 12 * 0.46 * PVIFA (i , 5 ) 138 * PVIFA (i , 5 ) PV of tax shield on depreciation [400 * PVIF (i,1) +240 *PVIF (i ,2) + 144 PVIF (i,3) +86.4 PVIF (i ,4 ) + 51.84 PVIF (i,5)] * 0.46 -A+B–C+d=0 Lease is to be accepted if IRR > marginal cost of capital

NEGOTIATING LEASE RENTAL • LB1 = break even LR of lessor ( lower limit) • LB = break even of LR of lessee( upper limit) • As long as rental is between LB1 & LB both lessor & lessee will enjoy positive NAL • Cost of equipment 30 lacs • Rate of depreciation 40% • Useful life 5 years • Lessee gets proposal of 25 ptpm advance monthly from lessor • Marginal cost of debt ,capital & tax rate for lessee is 17 (pre tax), 14 & 46% • Lessor requires a post rate return of 13 % on portfolio • Determine Break even for lessee & lessor • Comment upon spread between two break even

SOLUTION • LESSEE • Equipment cost 1000 • PV of LR 12 LB * PVIF A p (17 , 5 )= =12 LB * 1 / d 12 * PVIFA (17,5) =12 LB * 1.09 * 3.199 = 41.84 LB • PV of Tax on LR = 12 LB * PVIFA (14,5) * 0.46 = 18.95LB • PV of tax shield foregone [400* PVIF (14,1)+ 240 * PVIF (14,2) on depreciation +144 * PVIF (14,3) + 86.4 * PVIF (14,4) + 51.84 * PVIF( 14,5) ] * 0.46 = 326.88

SOLUTION contd. • PV of interest tax =[6.03LB*PVIF (14,1)+5.02LB*PVIF(14,2) shield ( on + 3.83LB * PVIF (14,3)+ 2.44LB * PVIF displaced debt ) (14,4) + 0.84 LB * PVIF (14,5)] * 0.46 = 6.26LB • ( DISPLACED ) DEBT AMORTISATION SCHEDULE YEAR LOAN O/S INTT PRINCIPAL RENTAL 1 41.84LB 5.97LB 6.03LB 12LB 2 35.87LB 6.98LB 5.02LB 12LB 3 28.89LB 8.17LB 3.83LB 12LB 4 20.72LB 9.56LB 2.44LB 12LB 5 11.16LB 11.16LB 0.84LB 12LB INTEREST CALCULATION ON DEBT AMORTISATION SCHEDULE • 12LB * 1.0899 – 12LB = 1.08LB • Amount outstanding at beginning * 0.17 – 1.08LB

SOLUTION contd. 1000 – 41.84 LB + 18.95 LB – 326.88 -6.26LB = 0 LB = 23.11 ptpm LESSOR Equipment cost 1000 PV of LR =12 LB1 * PVIF A p (13 , 5 )= =12 LB1 * 1 / d 12 * PVIFA (13,5) =12 LB1 * 1.0691 * 3.517 = 45.12 LB1 • PV of Tax on LR 12 LB1 * PVIFA (13,5) * 0.46 = 19.41LB1 • PV of tax shield foregone = [400* PVIF (13,1)+ 240 * PVIF on depreciation (13,2) +144 * PVIF (13,3) + 86.4 * PVIF (13,4) + 51.84 * PVIF( 13,5) ] * 0.46 = 332.50 • • • • •

SOLUTION contd. • - 1000 + 45.12 LB1 – 19.41 LB1 + 332.50 = 0 • LB1 =25.96 ptpm • INFERENCE • Maximum LR lessee would pay on 30 lacs would be 0.69 lacs ptpm (23.11 / 1000 * 30) while minimum LR lessor would accept Rs 0.78 lacs ptpm ( 25.96 / 1000 * 30). • There is no positive spread & bargaining area doesn’t exist