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 ) + E * kE
D+ E D+E
• Where
– KD & KE 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 cost of
• Tax shield on depreciation capital ( k )
• Tax shield on interest
• Residual value
 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 cash flow PV

1 2 2 * PVIF(12,1) = 1.79
2 4 4 * PVIF (12,2) = 3.19
3 6 6 * PVIF (12,3) = 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 LOAN O/S

1 14000 20000 34000 80000

2 11200 20000 31200 60000
3 8400 20000 28400 40000
4 5600 20000 25600 20000
5 2800 20000 22800 -
 PRACTICAL PROBLEM
• A loan of 100000/- is to be paid in 5 equal annual installments .if it
carries an interest of 14 % FLAT , find out installment

• SOLUTION
• 100000 * 14 % = 14000
• 14000* 5 = 70000
• EMI = 170000 / 5 = 34000
• YR INSTALL INTT PRINCIPLE LOAN 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
• Calculate PV of lease payments if marginal cost of debt is 20 %
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)

432 * i * PVIFA (20,3 )

i (12)
432 * 1.0887 * 2.106

= 991
 CONTD.
• B)
25 * 12 * PVIF A 12 ( 20,3 )

300 * i 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 lease rental 60 * 444 / 1000 * PVIFA(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 =[10.01 *PVIF (12,1) +7.18 * PVIF(12,2)
shield ( on + 3.87 * PVIF (12,3)] * 0.46
displaced debt ) = 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
• Considering data of previous question assume LR is 35/1000 payable monthly
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.
• PV on interest tax shield = [8.05 * PVIF (12, 1) + 5.13 * PVIF on
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
• 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 , 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