Lease  or Leasing

India witnessed the emergence of leasing as a formal instrument of industrial finance during the
late 1970s only.
Leasing or lease financing is generally used to finance fixed asset having high value.
Define
In its simplest form, leasing is a means of providing access to a fixed asset and may be defined as
a contract between two parties wherein one party (the lessor) provides an asset for use to
another party (the lessee) for a specified period of time (lease term) in return for specified
payments (rentals).
A lease represents a contractual aggrangement whereby the lessor grants the lessee the right to
use an asset in return for periodical lease rental payments.

Assets – Land
Building
Machinery
Equipments
Software
Vehicles etc
Lessor is the owner of the asset,
who give right of use of asset to
lessee for a specific period of time
and receives lease rentals
throughout the period.

Lessee is the party who takes the

asset or equipment for a specific
period of time and pays lease rentals
throughout the period.
Brief History & Facts – LEASING INDUSTRY IN INDIA
The Industrial Credit and Investment Corporation of India Limited (ICICI) was the first all India
financial institution to offer leasing.

The standard Chartered Bank was the first foreign bank to be granted permission to invest in
Cholamandalam Investment and Finance Company, Madras.

American Express Bank has been allowed to join hands with Tata Industrial Finance Company
Limited promoted by the Tata Group.

Gujarat Industrial Investment Corporation started Gujarat Lease Financing Ltd. for undertaking
leasing and related activities for assisting Small Scale Industries.

The National Small Industries Corporation (NSIC) entered the leasing scene to cater exclusively
to the needs of established small units

The first commercial bank to set up a leasing subsidiary was the State Bank of India (SBI).
Infrastructure Leasing and Financial Services Ltd. (ILFS), promoted by the Central Bank of India,
the Unit Trust of India and the Housing Development and Finance Corporation, is set up to serve
areas like highways, power and telecom.
There are two basic types of leasing structures in use:

An operating lease is a contract that allows the lessor, as owner, to retain legal
ownership of an asset but allows the lessee to enjoy the economic use of the asset for
a predetermined period before returning the asset to the lessor.
At the end of the lease period, the asset continues to be owned by the lessor.

In a finance lease, the lessor is the owner of the asset; however, at the end of the
lease period ownership is typically transferred to the lessee on the payment of a
residual value price of the asset which is usually pegged at 10% of the original asset
cost, or less.
Thus, a finance lease is essentially a finance transaction dressed up as a lease.
Below helps to compare financial leases and operating leases, from an Indian perspective -
Major leasing players in the market -

Leasing players in India can be categorised under the following heads:

a. Non-Banking Financial Companies

b. Non-Banking Non-Financial Companies - These companies provide operating leases of
several assets such as IT equipment, furniture, office equipment, equipment such as lifts and
security equipment in commercial property complexes, etc.
c. Specialised entities
Car finance companies
Captive financing arms of Vendors and OEM
Cab aggregators
Indian Railway Finance Corporation
The ability to acquire assets by way of lease rather than owning them has several benefits for
the lessee, including allowing them to keep a lighter balance sheet and free up resources for
working capital, among others.

Among several other benefits of leasing is also its potential for bringing down the cost of credit.
The lessor, with title over the asset, has better recovery rights, and therefore, has lower risk. This
allows the lessor to impose lower risk premiums while extending his financing. Reduced cost of
funding benefits the economy as a whole.
Lease Term -
The time period for which the asset is taken on lease is called as term period. Every lease has a
specific and definate period after which it expires.

On basis of the contract between lessor and lessee the period may be of two types.

1. Primary lease period : In the Primary Period the lessee (the Hirer) pays rentals based on the
amount financed plus interest. At the end of the Primary Period the lessee can dispose of the
goods acting as an agent for the lessor (the Finance Company).

2. Secondary lease period : If the lessee wishes to continue to use the equipment after the end
of the Primary Period, the option exists to extend the lease into the Secondary Period.
Secondary lease is provided at nominal rentals.
Consideration
Lease financing involves consideration in form of lease rentals to be paid by the lessee to lessor
for the specific term period.

The amount of lease rentals is decided taking into account

1. The cost of investment.
2. Cost of repair and maintenance
3. Depreciation
4. Taxes
5. Adjusted value of cash flow ( time value of money)
6. Life of Asset
Types of property lease

1. Double Net Lease - A double net lease is an agreement in which the tenant is responsible for
both property taxes and premiums for insuring the building. 

2. Gross Lease - A gross lease is a lease in which a flat rent fee encompasses rent and all costs
associated with ownership, such as taxes, insurance, and utilities. 

3. Triple Net Lease - A triple net lease assigns sole responsibility to the tenant for all costs
relating to the asset being leased, in addition to rent. 

4. Modified Gross Lease - A modified gross lease is a combination of a gross and net lease where
the operating expenses are both the landlord and tenant's responsibility. 

5. Recapture Clause - Recapture clause refers to a lease provision that allows the landlord to
terminate a lease and retain possession of a property. 

6. Graduated Lease - Graduated lease refers to an agreement under which a tenant and landlord
agree to a periodic adjustment of monthly payments.
Types of Leasing
3. LEVERAGED LEASE
4. SALE AND LEASE BACK
5. DIRECT LEASE
6. DOMESTIC AND INTERNATIONAL LEASE
A leveraged lease or leased lender is a lease in which the lessor puts up some of the money
required to purchase the asset and borrows the rest from a lender.
A leveraged lease is a lease agreement that is financed through the lessor with help from a third-
party financial institution. In a leveraged lease, an asset is rented with borrowed funds.

Leverage Lease Structure

Leverage leases can be more complex than a basic operating lease because leverage is involved.
The structure of the leveraged lease terms will depend on the lessor and their financing
relationships. The lessor may also be the financing institution who provides the loan in which
case they approve the loan for the borrower.
Leaseback, short for sale-and-leaseback, is a financial transaction in which one sells an asset
and leases it back for the long term; therefore, one continues to be able to use the asset but no
longer owns it.
The transaction is generally done for fixed assets, notably real estate, as well as for durable and
capital goods such as airplanes and trains.
The concept can also be applied by national governments to territorial assets; the government
of the United Kingdom proposed a leaseback arrangement whereby the with a 99-year
leaseback period, been in place prior to the handover of Hong Kong to mainland China.
Leaseback arrangements are usually employed because they confer financing, accounting or
taxation benefits.
Direct lease refers to a contractual arrangement between a lessor and a lessee where the lessor
leases out asset to the lessee.
There are two types of contract that come under direct lease.
The first is the bipartite agreement where the lessor already owns the property and directly
leases it out to the lessee.
The second is a tripartite agreement where the lessor, usually a bank or a lending institution,
purchases the property from a third-party (usually the manufacturer) and then leases it out to
the lessee.
Direct Lease vs Sale and Lease Back
A sale and lease-back agreement generally occurs in a situation where the lessee has already
acquired a property but needs to free up capital in order to maintain operational cash flows. In
such a case, the lessee sells their property to the lessor and then leases it back from the lessor
and makes monthly payments.
Direct lease, on the other hand, refers to the situation where the lessor directly leases the
property to the lessee. The lessor either owns the property already or buys it from the
manufacturer.
Types of Direct Lease Financing

1. True Tax Financing

2. Operating Lease Financing
3. Master Lease Financing

The Domestic Lease and International Lease are the types of leases classified on the basis of the
places where the parties to the lease agreement reside.

Domestic Lease: When all the parties to the lease agreement Viz. Lessor, lessee and the
equipment supplier are domiciled or belongs to the same country, is called as a domestic lease.

International Lease: The international lease refers to the type of lease agreement where one or
more parties to the lease agreement reside or are domiciled in different countries.
The methods used in evaluation of lease decision are as
follows -
1. Present Value Method

2. Cost of Capital Method

3. Bower-Herringer-Williamson Method
 1. Present Value Method

Under this method the present value of lease rentals are compared with the present value of
the cost of an asset acquired on outright purchase by availing a loan. In leasing, the tax
advantage in payment of lease rentals will reduce the cash outflow.

In case an asset is purchased by borrowing a loan, the repayment of principal and interest
charges on loan is considered as cash outflow and it is reduced by tax advantage of depreciation
claim and interest charge. The present value of the net cash outflows over the period of lease is
considered to ascertain the present value over the lease/loan period. The alternative with low
total present value of cash outflow will be selected.
 Example 1

ABC limited is interested in acquiring the use of an asset costing Rs. 5,00,000. It has two options:

(i) To borrow the amount at 18% p.a. repayable in 5 equal instalments or

(ii) To take on lease the asset for a period of 5 years at the year end rentals of Rs. 1,20,000.

Additional Information -
The corporate tax is 50% and the depreciation is allowed on w.d.v. at 20%. The asset will have a
salvage of Rs. 1,80,000 at the end of the 5th year.

You are required to advise the company about lease or buy decision.
Solution –
Conclusion -

As the present value of after-tax cash outflows under the leasing option is lesser than the
present value of after-tax cash outflows of the buying option, it is advisable to take the asset on
lease.
2. Cost of Capital Method

Under this method, the rate of cost of capital is calculated for the payments of instalments and
then it is compared with the cost of capital of the other available sources of finance such as
fresh issue of equity capital, retained earnings, debentures, term loans etc.

The lease option is chosen if the rate is lower than the cost of equity capital etc.

This method does not require the prior selection of any discounting rate.
 Example - 1

Bharti Airtel Limited is a telecommunication services provider looking to expand its 4G service to
Karnataka,
It is analyzing whether it should install its own telecom towers or lease them out from a
prominent tower-sharing company GTL Infra Ltd.

Leasing out 100 towers would involve payment of INR 5,000,000/- per year for 5 years.

Erecting 100 new towers would cost INR 18,000,000/- including the cost of equipment and
installation, etc.

The company has to obtain a long-term secured loan of INR 18 million at 5% per annum.

Owning a tower has some associated maintenance costs such as security, power and fuelling,
which amounts to INR 10,000/- per annum per tower.

The company’s tax rate is 40% while its long-term weighted average cost of debt is 6%.
The tax laws allow straight-line depreciation for 5 years.

Determine whether the company should erect its own towers or lease them out.
 Solution -
Annual cash out flows of leasing (Year 1 to Year 5) = INR 5,000,000 * (1 – 40%) = INR 3,000,000/-

18000000
= = 41,57,546/-
4.33

Period   1 2 3 4 5
Loan repayment A 41,57,546 41,57,546 41,57,546 41,57,546 41,57,546
Maintenance costs B 10,00,000 10,00,000 10,00,000 10,00,000 10,00,000
Depreciation D 36,00,000 36,00,000 36,00,000 36,00,000 36,00,000
Interest expense I 9,00,000 7,37,123 5,66,101 3,86,529 1,97,978
Total tax deductions T = B+D+I 55,00,000 53,37,123 51,66,101 49,86,529 47,97,978
Tax shield @ 40% t = 0.4×T 22,00,000 21,34,849 20,66,441 19,94,612 19,19,191
Net cash flows N = A+B–t 29,57,546 30,22,697 30,91,106 31,62,935 32,38,355
PV at 3.6% (6% x (1-40%)) P 0.965 0.932 0.899 0.868 0.838
PVCF NxP 2854774 2816275 2779935 2745688 2713474

Present Value of Cash Outflow Rs. 13910147/- (sum of PVCF)

Present Value of Cash Outflow in case of Lease

Annual Lease Rent [email protected]% PVCF

3,00,000 0.97 289575
3,00,000 0.93 279513
3,00,000 0.90 269800
3,00,000 0.87 260425
3,00,000 0.84 251375
 Present Value of Cash
Outflow Rs. 1350688

Since leasing has a lower present value of cash outflows, it should be the preferred option.
 Notes -

Depreciation is calculated on straight-line basis using the 5-year useful life

i.e. INR 18,000,000/5 = INR 3,600,000/-

The present value of cash outflows under both the options using the after-tax cost of debt which
is 3.6% (6% * (1-40%))
 3. Bower-Herringer-Williamson Method

Under this method, the financial and tax aspects of lease financing are considered separately.

The following steps are involved in evaluation of lease decision:

Step 1:
Make a comparison of the present value of cost of debt with the discounted value of gross
amount of lease rentals. The rate of discount applicable is being the gross cost of debt capital.
Then, obtain the total present value of a financial advantage/disadvantage of leasing.

Step 2:
Again compute the comparative tax benefit during the lease period and discount it at an
appropriate cost of capital. The total present value is the operating advantage/ disadvantage of
leasing.

Step 3:
When the present value of operating advantage of lease is more than its financial disadvantage,
then select the leasing. When the present value of financial advantage is more than operating
disadvantages, then select the leasing.
 Example - 1

Vindhya Papers Ltd. planning to install a captive generator set at its plant.
Its Finance Manager is asked to evaluate the alternatives either to purchase or acquire generator
on lease basis.

Additional Information –

Depreciation @ 20% p.a. on written down value.

Corporate tax rate 40%.
After tax cost of debt is 14%.

The time gap between the claiming of the tax allowance and receiving the benefit is one year.
Evaluate the lease or buy decision based on the above information.
Solution -
 Conclusion -

By applying the discounted cash flow technique, we can observe that the net present value of
cash outflow is higher in case of leasing decision i.e., Rs. 3,76,030 as compared to buying
decision it is only Rs. 3,30,557. The company may go for purchase of the generator instead of
acquiring on lease basis.