1

Lease Evaluation

2

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)}

3

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

4

Lease Evaluation - Lessee

• Financial • Non- Financial Factors

– Simple documentation– Expeditious sanction– Post sanction reporting– Flexibility– Financial Position/Experience of Lessor

5

Models for Evaluation

• Debt includes Lease

• Investments are funded with a mix of debt, equity & lease

• Weingartner’s Model

• Lease is a substitute to debt

• Equivalent Loan Model

• Bower-Herringer-Williamson Model(BHW)

• Bower Model

6

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

7

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)

8

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

9

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

10

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

• Total interest charges = Total lease rentals – initial investment

X 100

1616

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

1717

Distinguish between HP and Lease Point of Difference HP Lease

Ownership transfer Transferred after the payment of last installment

Never transferred

Depreciation claim for tax purpose

Hirer entitled to claim depreciation for tax purpose

Lessor claims depreciation for tax purpose

Tax benefit Only interest component in Hire purchase installment is allowed tax deduction and not portion of principle amount

Complete lease rent is allowed for tax deduction

Benefit of scrap value Hirer can enjoy the benefit of scrap value

Lessee cannot enjoy the benefit of scrap value, because he/she is not the owner of asset

Amount of finance Relative low when compared to leasing

Huge amount is involved

Maintenance of the asset

Hirer has to spent money on maintenance

If the lease is finance lease, lessee pays maintenance cost, otherwise lesser pays maintenance cost

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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.

1919

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)

2020

Determination of HP Installment

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

Pr incipal Amount Total Interest Over Installment Period at Flat Rate

Number of Installments

HPI =

2121

Hirer’s Rights and ObligationsRights: • 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 goodsObligations:• To pay the hire installments• To take reasonable care of the goods• To inform the owner where the goods will be kept

2222

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

2323

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)

• T = number of level instalments outstanding

• N = total number of instalments

N X (n+1) X Total Charge for credit

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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