Beta Estimation

Chapter - 22 : 

Chapter - 22 Asset-Based Financing: Lease, Hire Purchase and Project Financing

Lease Defined : 

2 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Lease Defined 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 : 

3 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Types of Leases Operating Lease Financing Lease Sale and Lease Back

Operating Lease : 

4 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Operating Lease Shot-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 : 

5 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Financial Lease 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 lease–Capital or Full pay-out leases.

Cash Flow Consequences of a Financial Lease : 

6 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Cash Flow Consequences of a Financial Lease Avoidance of the purchase price. Loss of depreciation tax shield. After–tax payments of lease rentals.

Sale and Lease Back : 

7 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Sale and Lease Back 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. In April 1989, Shipping Credit and Investment Corporation of India purchased Great Eastern Shipping Company bulk carrier, Jag Lata, for Rs 12.5 Cr and then leased it back to GESC on a 5 years lease, the rentals being Rs 28.13 Lakh per month. The ships WDV was Rs 2.5 Cr.

Commonly Used Lease Terminology : 

8 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Commonly Used Lease Terminology Leveraged Lease. Cross-border lease. Closed and open ended lease. Direct lease. Master lease. Percentage lease. Wet and dry lease. Net net net lease. Update lease.

Myths about Leasing : 

9 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Myths about Leasing Leasing Provides 100% Financing Leasing Provides Off-the-Balance-Sheet Financing. Leasing Improves Performance. Leasing Avoids Control of Capital Spending.

Advantages of Leasing : 

10 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Advantages of Leasing Convenience and Flexibility. Shifting of Risk of Obsolescence. Maintenance and Specialized Services.

Evaluating a Lease : 

11 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Evaluating a Lease Equivalent Loan Method. Net Advantage of a Lease Method. IRR Approach.

Equivalent Loan Method : 

12 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Equivalent Loan Method EL is that amount of loan which commits a firm to exactly the same stream of fixed obligations as does the lease liability. Method— 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 Advantage of a Lease Method : 

13 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Net Advantage of a Lease Method The direct cash flow consequences are: 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 : 

14 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Combination of Net Present Value of Investment and Net Advantage of Leasing

Lease Benefits to Lessor and Lessee : 

15 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Lease Benefits to Lessor and Lessee A lease can benefit both when their tax rate differs. Leasing pays if the lessee’s 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.

Internal Rate of Return Approach : 

16 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Internal Rate of Return Approach IRR of a lease is that rate which makes NAL equal to zero. Ao = Purchase Price. L = Lease Rentals. DEP = Depreciation T = Tax Rate OC = Operating Cost SV = Salvage Value

Hire Purchase–Conditions : 

17 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Hire Purchase–Conditions 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)

Difference : 

18 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Difference

Instalment Sale : 

19 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Instalment Sale 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.

Project Financing : 

20 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Project Financing 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 : 

21 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Characteristics A separate project entity is created that receives loans from lenders and equity from sponsors. The component of debt is very high in project financing. The project funding and all its other cash flows are separated from the parent company’s balance sheet. Debt services and repayments entirely depends on the project’s cash flows. Project assets are used as collateral for loan repayments. Project financer’s risk are not entirely covered by the sponsors guarantees. Third Parties like suppliers, customers. government and sponsors commit to share the risk of the project.

Project Financing Arrangements : 

22 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Project Financing Arrangements The Build Own Operate Transfer Structure. The Build Own Operate Structure. The Build Lease Transfer Structure.

Project Financing Risk and their Allocation : 

23 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Project Financing Risk and their Allocation Risks Project Completion Risk Market Risk Foreign Currency Risk Inputs Supply Risk Risk Mitigation By Government Country Risk Sector Policy Risk By Others Commercial Risk