CHAPTER 22 ASSET BASED FINANCING: LEASE, HIRE PURCHASE AND PROJECT FINANCING

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1 CHAPTER 22 ASSET BASED FINANCING: LEASE, HIRE PURCHASE AND PROJECT FINANCING Q.1 Defie a lease. How does i differ from a hire purchase ad isalme sale? Wha are he cash flow cosequeces of a lease? Illusrae. A.1 A lease is a agreeme for he use of he asse for a specified real. The ower of he asse is called he lessor ad he user he lessee. The leases are of wo ypes, i.e., (1) operaig leases which are shor erm ad cacellable, ad (2) fiacial leases which are log erm o-cacellable. The mos compellig reaso for leasig equipme raher ha buyig i is he ax advaage of depreciaio which ca muually beefi boh he lessee ad lessor. I Idia, lease ca prove hady o hose firms which cao obai loa capial from ormal sources. I he case of lease, he compay ca acquire he asse wihou immediaely payig for I; depreciaio is a deducible expeses; ad lease reals are also deducible expeses, so i saves axes. Uder a higher price arrageme, like i a lease, he hire purchaser is able o avoid he payme for he purchase of he asse ow, ad isead pays higher purchase isalmes over a specified period ad ime as per agreeme. The hire purchaser becomes he ower of he asse oce he has paid all isalmes. Ulike he lease, he is eiled o claim depreciaio as well as he salvage value of he acquired asse. Hire purchase arragemes differ from isalme sale arrageme i erms of he imig of owership. Uder hire purchase, owership passes o he hire purchaser o he payme of he las isalme, while uder isalme sale owership is rasferred oce he agreeme has bee made bewee he buyer ad he seller. Q.2 Wha are he myhs ad advaages of a lease? A.2 A umber of advaages, which really are myhs, are claimed for a lease.

2 a) I is miscocepio abou leasig ha i provides 100% fiacig for he asses. Mos lease agreeme require lease reals i he begiig of he period. I leasig, he firm acquires he asse ad icurs he liabiliy o make fixed paymes i fuure. b) I is also myh ha leasig provides off-he balace shee fiacig. Leasig affecs he firm s deb capaciy; ha is, is deb-servicig abiliy. Pracically, he coracual obligaios of ay form reduce he deb-servicig capaciy of a firm. c) I is a myh ha leasig absolves a firm from capial ivesme evaluaio. I also requires he screeig of ivesmes decisio sice a log erm fiacial commimes are o be made. If a firm is icurrig losses or makig low profis, i cao ake he full advaage of he depreciaio ax shield o purchase of asses. I is, herefore, sesible for i o le he leasig compay (lessor) ow he asses, ake full advaage of ax beefis, ad expec ha he lessor passes o a leas some par of he beefis i he form of low lease reals. So, boh paries, i.e., lessee ad lessor, may sad o gai fiacially (of course a he cos of goverme which will lose ax reveues!). Lease is suiable, if a asse is eeded for a shor period. I provides he flexibiliy o ailor lease paymes o he lessee s cash flow. Q.3 Explai ad illusrae he equivale loa mehod of lease evaluaio. A.3 Equivale loa amou is ha amou of loa which commis a firm o exacly he same sream of fixed obligaios as does he lease liabiliy. This case flow ca be said o service he lease. The equivale loa isalme (EIL) mehod cosiss of he followig seps for evaluaio of fiacial lease. 1) Fid ou icremeal cash flows from leasig. 2) Deermie he amou of equivale loa such icremeal cash flows ca service. 3) Compare he equivale loa so foud wih lease fiace.

3 4) If he lease fiace is more ha equivale loa, he firm should fiace he asse by leasig. The ELI is, i fac, he prese value of lease cash flows ad is give by followig equaio. Equivale loa = PV of cash flows of a lease EL = = 1 (1 T)L (1 + i(1 T)) + DTS Where T is ax rae; L is lease isalme; DTS is depreciaio ax shield ad equals T DEP; i is ieres rae ad is ime period of lease. Q.4 Wha is e advaage of a lease? How is i calculaed? A.4 The e advaage of leasig is equal o he purchase price of he asse (avoided) less prese value of lease flows. The formula give above (see aswer o Q 3) is used o calculae e advaage of leasig. I deoes he icremeal advaage over he e prese value of buyig he asse hrough ormal fiacig chaels. A posiive e advaage of leasig does o imply ha he asses should be acquired, i implies advaage o leasig. So, before akig decisio, e prese value of asse should be assessed as a ivesme. I is possible ha leasig may make a fiacially uaracive asse ivesme worhwhile. Q.5 Wha is he differece bewee equivale loa ad e advaage of lease mehods of he lease evaluaio? A.5 Fiacial lease ivolves fixed obligaios i he form of lease reals. Thus, i is like a deb ad ca be evaluaed ha way. Give he lease reals ad ax shields, oe ca fid he amou of deb which his cash flow ca service. This is equivale loa. If equivale loa is more ha he cos of he asse, i is o worh leasig he equipme. Lease evaluaio ca be doe by calculaig he e advaage of lease. Afer-ax lease reals ad ax shields may be discoued a he afer ax borrowig rae while operaig coss ad salvage value a he firm s cos of capial o fid ou NAL. I he followig formula, we assume ha he lessor will ake care of he operaig ad maieace expeses if he asse is leas isead of beig ough. NAL (1 T)L + DTS = Ao + = 1 [1 + i(1 + T)] = 1 (1 T)OC (1 + k) 1 ATSV (1 + k)

4 Where A o is he purchase price of he asse avoided, DTS is he depreciaio ax shield; T is he ax rae; i is he ieres rae o borrowig; L is he lease isalme; OC 1 is he operaig cos i year avoided; k is he afer-ax cos of capial of he firm; ad ATSV is he afer-ax salvage value of he leased asse a he ed of he life,. Q.6 I makes sese for compaies ha pay o axes o lease from compaies ha do. Explai. A.6 A firm ha is icurrig losses or makig low profis, i cao ake full advaage of he depreciaio ax shield o purchase of asses. I is, herefore, sesible for i o le he leasig compay (lessor) ow he asse, ake full advaage of wo beefis, ad passes o some beefis i he form of reduced lease reals o he lessee. Boh he lessor ad lessee will gai fiacially. Q.7 Wha is a leveraged lease? Wha are is meris ad demeris? A.7 Uder a leveraged lease, four paries are ivolved: he maufacurer of he asse, he leder from whom he lessor borrows a subsaial porio of he asses purchase price, he lessor ad he lessee. I a leveraged lease, he lessor makes subsaial borrowig, e.g., 80% of he asse s purchase price, ad provides remaiig amou. The lessor claims all ax beefis relaed o he owership of he asse. Leders, geerally he large fiacial isiuios, provide loas o a o-recourse basis o he lessor. Their deb is serviced exclusively ou of he lease proceeds. The lessor morgages he asse o he leders. The leveraged lease creaes a high degree of leverage. I is quie useful for large capial equipme wih log ecoomic life, say, 20 years or more. Q.8 Wha is he hire purchase fiacig? How does i differ from he lease fiacig? A.8 I hire purchase fiacig, here are hree paries: he maufacurer, he hiree ad he hirer. The hiree may be a maufacurer, or a fiace compay. The maufacurer sells asse o he hiree who sells i o he hirer i exchage for he payme o be made over a specified period of ime. The hire purchase fiacig have hree disicive feaures:

5 1) The ower of he asse (hiree or maufacurer) gives he possessio of he asse o he hirer o agreeme. 2) The owership will rasfer o he hirer o he payme of all isalmes. 3) The hirer will have he opio o ermiae he agreeme before he rasfer of owership of he asse. I he case of hire purchaser, hirer is eiled o claim depreciaio, while i case of lease, lessee is o eiled o claim depreciaio. Hirer ca charge oly ieres porio of HP paymes as expeses for ax compuaio, while i case of lease fiacig, lessee ca charge he eire lease paymes as expeses for ax compuaio. O payme of all isalmes as agreed, he hirer become ower of he asse ad ca claim is salvage value. Lessee does o become he ower of he asse. Therefore, he has o claim over he asse s salvage value. I case of lease, he asse revers back o he lessor a he ed of lease period.