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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
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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.
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.
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
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.
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.
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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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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)
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
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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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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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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Risks
1. 2. 3.
4.
Project Completion Risk Market Risk Foreign Currency Risk Inputs Supply Risk By Government
1.
2. 3.
Risk Mitigation
1.
Debt
Bonds
Equity
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on equity Risk measurement Impact of guarantees Financial structure Taxes Financial distress Government restrictions