LEASING

An Overview

Characteristics
Periodical payment of rentals

Lessor

Lessee
Right to use an asset for
a fixed period of time

Ownership rests with the lessor

Term
Lease

Period = Lease agreement is

operational
Perpetual lease
Primary

Lease

Period
Secondary

Tests for Financial Lease

Substance Test:

Lessee Compliance with No.2 point

Full Payment Test:

Lessor Compliance with No.8 point

Transfer of Title Test: Lessee has an option to buy the

asset

Lease Term Test:

life

Lease term extends to the assets

Myths about Leasing

Off-balance sheet financing

No evaluation for capital expenditure Cash flow

consequences?

Better Performance Possible to enhance ROI, but

the
transaction should yield a positive
NPV

Advantages of Leasing

Advantages to the lessor:

1. Stable Business Lessees continued patronage
2. Sale of spare parts
3. Second-hand market
4. Tax benefits
5. Fillip to capital market
6.Easy finance

Advantages of Leasing

Advantages to the Lessee:

1. Efficient use of funds
2. Cheaper Source
3. Enhanced borrowing capacity 4. Off-balance sheet borrowing 5. Tax benefits
6. Guard against obsolescence
and
asset
lease

No capital investment
than buying option
Lower D/E Ratio
do
- Lessee can terminate the
lease at any time
take up another
under fresh

Limitations

Disguised form of debt financing

Loss of depreciation tax shield, when depreciation
rates are high and leasing is preferred over buying
Possibility of double sales tax in certain states
Unfavourable capital gearing for the lessee
No ownership
Default Risk
Working Capital not considered
Indiscriminate finance

Tax Aspects of Leasing

Lessor:

Deduction of depreciation from taxable income

Income from lease rentals is taxable under Profits and Gains
of Business and Profession
Deductible expenses:

Depreciation
Rent, rates, taxes, repairs and insurance
Amortization of preliminary expenses
Interest on borrowed capital
Bad debts
All expenses incurred in furtherance of business
Entertainment expenses (with a cap)
Travel expenses (as per approved norms)

(See Illustration No.3.5 M Y Khan)

 Lessee:

Allowability of lease rentals allowed as normal

business expenditure if they are not i. of capital nature, ii.
Personal expense and relates only to the business purpose.

Deductibility of Incidental Expenses Repairs,

Maintenance, Insurance, Finance Charges,(Incidental)
Installation expense (revenue expense in the year of
incurrence)

Tax Planning
Lessee:

Flexible Restructuring of Lease Rentals

Substantial part of the lease rentals payable in the first year and a
very small fraction during the remaining lease term
Lower rentals in earlier years and higher in later years depending
on cash flows
Purely tax-driven structure of lease rentals not allowed by the IT
authorities

(See Illustration No.3.6 M Y Khan)

Transfer of Investment-related Unabsorbed Tax Shield

Lessee firm enjoys 100% tax deduction (exports) Tax shield on

fresh capital investment would not have any impact on its cash
flows Tax shields can be transferred to the lessor who will
consider lower lease rentals

(See Illustration No.3.7 M Y Khan)

Funding Aspects of Leasing

Deposits Major source of finance

Bank Borrowings

Maximum Limit 10 times of NOF including deposits,

borrowings from banks/FIs, debentures, bonds
Maximum bank borrowings would be 3 times of NOF where
75% of the companys assets are in equipment leasing and
where 75% of its gross income is from leasing
NOF = Paid up Capital + Free Reserves Accumulated
balance of loss, where Free Reserves represent share
premium account, capital and debenture redemption reserves
and any other reserve not created for payment of any future
liability or for depreciation in assets or for bad debts or a
reserve created by revaluation of assets
RBI has freed the restrictions w.e.f.April 1997

Nature of Facility based on the expected flow of lease

rental receivables

Maximum Permissible Bank Finance

Calculate outstanding credit for next five years
Calculate relevant Drawing Power against that particular
transaction
Exclude a. Funds raised from financial/inv. Institutions
b. DPGs provided by banks, and c. Assets created against
DPGs issued by banks

This will imply bank finance will be to an extent of 2 3

times of NOF.

 Requirements

for Bank Finance

Current Ratio Minimum 1.33

Reports - (See page no. 203 Dr S Gurusamy)

Lessees Perspective of Leasing

Lease rental payments are similar to payments of

interest on debt
Hence, alternative to borrowing
Choice between debt financing versus lease financing
Decision-criterion Net Present Value of Leasing/Net
Advantage of Leasing NPV(L)/NAL
Discount Rate used is the marginal cost of capital for
all cash flows except lease payments and tax cost of
debt for lease payments
Value of interest tax shield is included as a foregone
cash flow in the computation of NPV(L)/NAL

NPV(L)/NAL
NPV(L)/NAL = Investment Cost
- PV of lease payment (discounted by Kd)
- PV of tax shield on lease payment (discounted by
Kc)
- Management Fee
+ PV of tax shield on management fee (disc.by Kc)
- PV of Depreciation shield (discounted by Kc)
- PV of Interest Shield (discounted by Kc)
- PV of residual/salvage value (discounted by Kc)
Where Kc = Post-tax marginal cost of capital, and
Kd = Pre-tax cost of long-term debt

NPV(L)/NAL negative means leasing alternative

should be used.
NPV(L)/NAL positive means borrowing alternative
would be preferable.
Alternative approach is

Determine the PVs of cash outflows after taxes under both the
alternatives
Select the alternative with the lower PV of cash outflows

(See Illustration No.4.1 M Y Khan)

Break-Even Lease Rental (BELR)

for lessee

The point where the Net Advantage of Leasing (NAL)

is zero.
The rental at which the lessee is indifferent between
lease financing and borrowing/buying.
Maximum level of rental which the lessee is willing to
pay
If the BELR > the actual rental, the lease proposal
would be acceptable.

(See Illustration No. 4.4 M Y Khan)

Lessors Perspective of Leasing

Whether

to accept a lease proposal, or to

choose from alternative proposals
Determine break-even rental for the lessor,
negotiation and fixation of lease rentals
(See Illustration No.4.5 M Y Khan)
BELR for a lessor minimum lease rental which he
can accept
NAL/NPV(L) at this level of rental is zero.
Discount Rate to compute NAL is the marginal over-all
cost of funds to the lessor
(See Illustration No. 4.6 M Y Khan)