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LEARNING OBJECTIVES

Define

lease and highlight its true advantages Explain the methods for evaluating a lease Discuss the concept of a leveraged lease Highlight the difference between hire purchase financing and lease financing Focus on project financing as a special mechanism for financing large projects

Lease Defined
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Lease

is a contract under which a lessor, the owner of the assets, gives right to use the asset to a lessee, the user of the assets, for an agreed period of time for a consideration called the lease rentals. In up-fronted leases, more rentals are charged in the initial years and less in the later years of the contract. The opposite happens in back ended leases. Primary lease provides for the recovery of the cost of the assets and profit through lease rentals during a period of about 4 or 5 years. It may be followed by a perpetual, secondary lease on nominal lease rentals.

Types of Leases
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1.

2.
3.

Operating Lease Financial Lease Sale-and-lease-back

Operating Lease
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Short-term,

cancelable lease agreements are called operating lease. Tourist renting a car, lease contracts for computers, office equipments and hotel rooms. The Lessor is generally responsible for maintenance and insurance. Risk of obsolescence remains with the lessor.

Financial Lease
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Long-term,

non-cancelable lease contracts are known as financial lease. Examples are plant, machinery, land, building, ships and aircrafts. Amortise the cost of the asset over the terms of the leaseCapital or Full pay-out leases.

Sale and Lease Back


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Sometimes,

a user may sell an (existing) asset owned by him to the lessor (leasing company) and lease it back from him. Such sale and lease back arrangements may provide substantial tax benefits.

Cash Flow Consequences of a Financial Lease


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Avoidance

of the purchase price Loss of depreciation tax shield Aftertax payments of lease rentals

Advantages of Leasing
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1.
2. 3.

Convenience and Flexibility Shifting of Risk of Obsolescence Maintenance and Specialized Services

Evaluating a Lease
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Equivalent

Loan Method Net Advantage of a Lease Method IRR Approach

Equivalent Loan Method


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EL is that amount of loan which commits a firm to exactly the same stream of fixed obligations as does the lease liability. Method
1. 2.

3.

Find out incremental cash flows from leasing. Determine the amount of equivalent loan such cash flow can service. Compare the equivalent loan so found with lease finance.

Net Present Value and Net Advantage of Leasing


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The direct cash flow consequences are:


1. 2. 3.

The purchase price of the asset is avoided. The depreciation tax shield Is lost. The after tax lease rentals are paid.

The net present value of these cash flows at after tax cost of debt should be calculated. If it is positive, lease is beneficial.

Combination of Net Present Value of Investment and Net Advantage of Leasing

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Lease Benefits to Lessor and Lessee


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lease can benefit both when their tax rate differs. Leasing pays if the lessees marginal tax rate is less than that of the lessor. In fact in a lease, the lessee sells his depreciation tax shield to the lessor. In the absence of taxes it is hard to believe that leasing would be advantageous if the capital markets are reasonably well functioning. Gain of both is loss to the government in form of taxes.

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Leasing Benefits Come from


lessor and lessee, gain at governments expense because of the difference in their tax rates. The government gains from the tax on lease rentals while it loses on depreciation and interest tax shields.
Both,

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(NAL) including Operating Costs and Salvage Value

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Internal Rate of Return Approach

IRR of a lease is that rate which makes NAL equal to zero.


1. 2. 3. 4. 5. 6.

Ao = Purchase Price. L = Lease Rentals. DEP = Depreciation T = Tax Rate OC = Operating Cost SV = Salvage Value
n

Ao
t 1

1 T L OC
1 r
t

TDEPt

SV n

1 r

LEVERAGED LEASE
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Hire PurchaseConditions
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The

owner of the asset (the Hirer or the manufacturer) gives the possession of the asset to the Hirer with an understanding that the Hirer will pay agreed instalments over a specified period of time. The ownership of the asset will transfer to the hirer on the payment of all instalments. The Hirer will have the option of terminating the agreement any time before the transfer of ownership of assets. ( Cancellable Lease)

Hire purchase financing

Difference between Leasing and Hire Purchase Financing


Hire purchase Leasing Hire purchaser can claim depreciation Lessee cant claim depn

Only interest included in annual hire purchase payments tax deductible and not the principle portion Hire purchaser can claim salvage value once all payments are done

Entire lease rentals are tax deductible

Lessee cant claim salvage value , even if he has paid all lease rentals.
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Instalment Sale
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Instalment

Sale is a credit sale and the legal ownership of the asset passes immediately to the buyer as soon as the agreement is made between the buyer and the seller. Except for the timing of the transfer of ownership, instalment sale and hire purchase are similar in nature.

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Evaluation of Hire Purchase Financing


The

hiree charges interest at a flat rate, and he requires the hirer to pay equal instalments at each period.

Project Financing
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Scheme

of financing a particular economic unit in which a lender is satisfied in looking at the cash flows and the earnings of that economic unit as a source of funds, from which a loan can be repaid and to the assets of the economic unit as a collateral for the loan. It is different from the traditional form of financing, i.e., the corporate financing or the balance sheet financing.

Characteristics
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1.
2. 3. 4. 5. 6.

Separate project entity Leveraged financing Cash flows separated Collateral Sponsors guarantees Risk sharing

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Project financing allows sponsors to:


projects larger than what the companys credit and financial capability would permit, Insulate the companys balance sheet from the impact of the project, Use high degree of leverage to benefit the equity owners.
Finance

Financing Arrangements for Infrastructure Projects


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1. 2. 3.

The Build Own Operate Transfer (BOOT) Structure. The Build Own Operate (BOO) Structure. The Build Lease Transfer (BLT) Structure.

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BOOT/BOO Structure of a Power Plant

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The Built-Lease-Transfer (BLT) Structure

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Project Financing Risk and their Allocation

Risks
1. 2. 3.

4.

Project Completion Risk Market Risk Foreign Currency Risk Inputs Supply Risk By Government
1.
2. 3.

Risk Mitigation
1.

Country Risk Sector Policy Risk Commercial Risk

Financial Structure of Infrastructure Projects


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Debt

Bonds
Equity

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Appropriate Return to Equity and Financial Structure in Infrastructure Project Financing


Return

on equity Risk measurement Impact of guarantees Financial structure Taxes Financial distress Government restrictions

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