LEASE EVALUATION : LESSEE ANGLE
1) FINANCIAL EVALUATION 2) 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 )
D+ E
+
E
* k E
D+E
• Where – K D & K E 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 fees • Tax shield on depreciation • Tax shield on interest • Residual value
cost of
capital ( k )
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 1 2 3
cash flow
2 4 6
PV
2 * PVIF(12,1) = 4 * PVIF (12,2) = 6 * PVIF (12,3) =
1.79 3.19 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 100000 1 29129 14000 15129 84871 2 29129 11882 17247 67624 3 29129 9467 19662 47962 4 29129 6715 22414 25548 5 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 1 2 3 4 5
14000 11200 8400 5600 2800
20000 20000 20000 20000 20000
34000 31200 28400 25600 22800
LOAN O/S
80000 60000 40000 20000 -
PRACTICAL PROBLEM • A loan of 100000/- is to be paid in 5 equal equal annual installments .if it carries an interest of 14 % FLAT , find out installment • SOLUTION • 100000 * 14 % = 14000 • 14000* 5 = 70000 • EMI = 170000 170000 / 5 = 34000 • YR INSTA NSTALL LL
INTT INTT PRIN PRINC CIPLE IPLE LO LOA AN O/S 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 Calculat e PV of lease payments if marginal cost of debt is 20 % • Calculate 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) 3) 432 * i
* PVIFA (20,3 )
i (12) 432 * 1.0887 * 2.106 = 991
CONTD. • B) 25 * 12 * PVIF A
300 * i
12 ( 20,3 )
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 leas leasee renta rentall 60 * 444 / 1000 1000 * PVIF PVIFA( A(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 shield ( on displaced debt )
=[10.01 *PVIF (12,1) +7.18 * PVIF( 12,2) + 3.87 * PVIF (12,3)] * 0.46
= 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 data of previous previous question assume LR is 35/1000 payable monthly • Considering data 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. [8.05 * PVIF (12, (12, 1) + 5.13 5.13 * PVIF on • PV on interest tax shield = [8.05 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 disadvantageous • 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 prof it , 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
