LEASE EVALUATION : LESSEE ANGLE

1) FINANCIAL EVALUATION2) 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 k D * ( 1 – T ) + E * k E

D+ E 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 feescost 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 1 yr 2

2 yr 4

3 yr 6

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

SOLUTION • Yr cash flow PV

1 2 2 * PVIF(12,1) = 1.792 4 4 * PVIF (12,2) = 3.193 6 6 * PVIF (12,3) = 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 1000001 29129 14000 15129 848712 29129 11882 17247 676243 29129 9467 19662 479624 29129 6715 22414 255485 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 LOAN O/S

1 14000 20000 34000 800002 11200 20000 31200 600003 8400 20000 28400 400004 5600 20000 25600 200005 2800 20000 22800 -

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 60 lacs

• Rate of depreciation 40 %

• Useful life 4 years

• Salvage value 5 lacs

• Cost of debt (comparable to lease ) 17%

• Cost of capital 12%

• Tax rate is 46%

• Lease option (payable annually in arrears) 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 LOAN O/S INTT PRINCIPAL RENTAL

1 58.87 10.01 16.63 26.64

2 52.24 7.18 19.46 26.64

3 22.78 3.87 22.78 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 = 27.46

• 60.70 *17 % = 10.319

• 27.46 – 25.2 = 2.26

• 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