Lease Evaluation

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 Basic Mathematics
• Use of
• PVIF/ PVIFA
• Type of Annuity
• Regular Annuity (PVIFA) Vs Annuity-Due (PVIFA)
• Regular Annuity PV = A * PVIFA (i,n)
• Annuity Due = A + A* PVIFA (i, n-1)
• Flat Rate Vs Effective Rate of Interest
• Effective Rate = 2F{n/(n+1)}

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 PV of Annuity payable at interval
less than a year
• Lease quotes
Lease Term Rate
3 years 36PTPM (Arrear)
5 years 25PTPM (Advance)
Marginal Cost of Debt = 16%
PV (3 Years) = (36*12) * PVIFA 12(16%,3)
= 432 * i/i^12 * PVIFA (16%,3)
=432 * 1.0714 * 2.246 = 1039.549

PV (5 Years) = (25*12) * PVIFA 12 (16%,5)

= 300 * i/d^12 * PVIFA (16%,5)
= 300 * 1.0847 * 3.274 = 1065.392

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 Lease Evaluation - Lessee
• Financial
• Non- Financial Factors
– Simple documentation
– Expeditious sanction
– Post sanction reporting
– Flexibility
– Financial Position/Experience of Lessor

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 Models for Evaluation
• Debt includes Lease • Lease is a substitute
to debt
• Investments are
funded with a mix of • Equivalent Loan
debt, equity & lease Model
• Bower-Herringer-
• Weingartner’s Model Williamson
Model(BHW)
• Bower Model

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 Weingartner’s Model
• Leasing and buying as two ways of investing in
an asset
• Evaluate lease as an Investment alternative
– Lease if NPV(L) > NPV(B) > 0
– Buy if NPV (B) > NPV (L) > 0
• Discount Rate – Marginal Cost of Capital
• K = D/(D+E) x kD(1-T) + E/(D+E) x kE

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 Weingartner’s Model
• NPV (B) = - Initial Investment + PV of EBDIT x (1-T) +
PV (Tax Shield of Depreciation) + PV of Net salvage
Value
• NPV (L) = -PV of Lease Rental + PV of EBDIT x (1-T) +
PV (tax Shield on Lease Rentals) – Management Fee +
PV (Tax Shield on Management Fee)
• NAL (Net Adv of Leasing) = NPL – NPV = Initial
Investment - PV (Tax Shield of Depreciation) - PV of Net
salvage Value - PV of Lease Rental + PV (tax Shield on
Lease Rentals) – Management Fee + PV (Tax Shield on
Management Fee)

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 Equivalent Loan Model
• The decision to invest has already been made
• Asset will be debt financed
• Lease is a substitute to debt
• Discount rate = Marginal Cost of Debt – pre tax
for lease rentals and post tax for others
• Net value of lease = Initial Investment - PV (Tax Shield
of Depreciation) - PV of Net salvage Value - PV of Lease
Rental + PV (tax Shield on Lease Rentals) –
Management Fee + PV (Tax Shield on Management
Fee) – PV (Interest tax shield on displaced debt)
• Amount borrowed = PV of Lease payment at K
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Bower-Herringer-Williamson (BHW)
• Cash Flow Stream – Financing & Operating
• FAL = PV of Loan Payments/Initial Investment –
P.V. of Lease Payments
• OAL = PV of Lease Related tax Shield – PV of
loan related tax shields (ie interest and
depreciation) – PV of Residual Value
• If FAL+OAL > 0 -Lease
• If FAL + OAL < 0 - Borrow and Buy
• Discount Rate
• PV of Lease Payment – pre-tax marginal cost of debt
• OAL – post tax marginal cost of capital
• Amount Borrowed = Cost of Asset
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 Bower Model
• COP (cost of purchase) = Initial Investment - PV
(Tax Shield of Depreciation) - PV of Net salvage Value
• COL (cost of Lease) = PV of Lease Rental - PV (tax
Shield on Lease Rentals) + PV (Tax Shield on Interest)
• Decision
• COL<COP – Lease
• COL > COP – Buy
• Discount Rate
• Tax Shields - unspecified rates
• Net salvage value – marginal cost of capital
• Lease Rental – pre-tax cost of debt
• Amount borrowed = Cost of Asset / Initial
investment
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 Suggested Framework
• NAL= Initial Investment - PV (Tax Shield of Depreciation)
- PV of Net salvage Value - PV of Lease Rental + PV
(tax Shield on Lease Rentals) – Management Fee + PV
(Tax Shield on Management Fee) – PV (Interest tax
shield on displaced debt
• Amount borrowed = PV of Lease payment at pre tax cost
of debt
• Discount Rate
• PV of Lease Payment – pre-tax marginal cost of
debt
• Tax shield/salvage value – marginal cost of capital

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 Lease evaluation – Lessor’s Point
• Break even lease rentals where NAL (net
advantage of leasing) is ZERO
• NAL = - Equipment cost –PV of tax on
lease rentals +PV of dep tax shield + Mgt
fee – PV of tax on mgt fee +PV of salvage
value
• Use post tax cost of capital

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 Break Even Lease Rental
• BE rentals for lessor (previous slide)
• BE rentals for lessee (suggested
framework)
• Spread / Viable deal

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 Gross Yield - Lessor
• Pre tax analysis
• Gross Yield based pricing is where PV
(lease rentals)+ PV of sal.value +Mgt fee
= Investment+Initial direct cost
• Gross yield = pre tax marginal cost of
capital + desired spread (based on risk)

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 Add-on Yield
• Similar to flat rate analysis
• Add on yield (%)

Total Interest charges over the lease period

Lease period in years x Initial investment X 100

• Total interest charges = Total lease rentals – initial

investment

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 HIRE PURCHASE
• Hire purchase is a conditional sale of contract.
• Essentials:
– Owner (hirer)
– User (hirer)
– Asset
– HP installment

• Two crucial points

– Option to terminate
– Option to purchase

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 Distinguish between HP and Lease
Point of Difference HP Lease

Ownership transfer Transferred after the Never transferred

payment of last installment
Depreciation claim for tax Hirer entitled to claim Lessor claims
purpose depreciation for tax purpose depreciation for tax
purpose
Tax benefit Only interest component Complete lease rent is
in Hire purchase installment allowed for tax deduction
is allowed tax deduction and
not portion of principle
amount
Benefit of scrap value Hirer can enjoy the benefit of Lessee cannot enjoy the
scrap value benefit of scrap value,
because he/she is not the
owner of asset
Amount of finance Relative low when compared Huge amount is involved
to leasing
Maintenance of the asset Hirer has to spent money on If the lease is finance
maintenance lease, lessee pays 17
maintenance cost,
 HP vs INSTALLMENT PURCHASE

Hire purchase should be distinguished from installment sale

wherein property passes to the purchaser with the payment of
the first installment.
But in case of HP (ownership remains with the seller until the last
installment is paid) buyer gets ownership after paying the last
installment.

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 Terms of HP agreement

• The cash price of the goods

• The HP price
• The deposit
• Down payment
• Flat rate of interest
• Period
• Frequency and mode of payments (adv/arr)

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 Determination of HP Installment
• HP installment: Equals to principal amount plus
total interest dividend by number of installments

HPI = Pr incipal Amount + Total Interest Over Installment Period at Flat Rate
Number of Installments

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 Hirer’s Rights and Obligations
Rights:
• To buy goods at any time by giving notice
• To return the goods to the buyer
• With consent of owner assign burden and benefit to third party
• Recover the goods plus damages for loss if owner wrongfully
repossesses the goods
Obligations:
• To pay the hire installments
• To take reasonable care of the goods
• To inform the owner where the goods will be kept

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 Owner’s Rights
• To forfeit the deposit
• To retain the installments already paid and recover the balance
due
• To repossess the goods
• To claim damages for any loss suffered

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 Split of HP Installment into interest and
principal amount

• There are three methods available in vogue:

1. Straight line splitting [equally on the tenure of hire)
2. Sum-of-Digits or Sum-of-Values-Digits [in proportion to the
number of installments or the value of installments (unequal
installment are) outstanding
3. Capital Recovery Method (Repayment of a part of capital)

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 Effective Rate
• Also called ANNUAL PERCENTAGE
RATE
• 2F x n/ (n+1) if in arrears
• 2Fx n/(n-1) if in advance
• F = flat rate of interest
• Eff rate in deposit linked plan is ???? than
in eff rate in down payment plan

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 Interest rate rebate
• Accurate – effective interest rate / IRR
• Rule of 78 / sum of years digit method
• Rebate = t x (t+1) X Total Charge for credit
N X (n+1)
• T = number of level instalments outstanding
• N = total number of instalments

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 HP vs Lease : Hirer angle
• Cost of leasing (COL) = PV of lease
rentals at KD + LMF –PV of tax shield on
lease rentals at WACC-PV of tax shield on
LMF at WACC
• Cost of HP (COH)= Down payment+PV of
hire payments at KD + service fee-PV of
tax shield on hire payments and service
fee at WAC– PV of tax shield on dep at
WACC– PV of sal value at WACC
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HP vs Lease : Fin co evaluation
• WACC (marginal cost of cap) used
• NPV (lease)= - initial investment-initial direct
cost + PV of rentals + LMF + PV of tax shield on
direct cost and depreciation + PV of sal.val - PV
of tax on rentals and LMF
• NPV (HP) = -Loan amt-Initial direct cost +
service fee + PV of HP instals-PV of tax on fin
income + PV of tax shield on direct cost-PV of
tax on service fee

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