LEASE FINANCING

Characteristics of Term Loans

Term loans are a type of financing agreement where a lender provides funds to a borrower with the
expectation of repayment over a specific term, usually ranging from one to ten years. They are often used
to finance fixed assets like equipment, machinery, or real estate. The loan amount, interest rate, and
repayment schedule are agreed upon in advance.

Suppliers of Term Loans

Suppliers of term loans typically include commercial banks, credit unions, and other financial institutions.
Some specialized lenders, such as development banks or investment funds, may also provide term loans
for specific sectors or projects. The selection of a lender can depend on factors like interest rates, terms,
and industry specialization.

Amortized Loan
An amortized loan is a type of loan with scheduled, periodic payments that are applied to both principal
and interest. Each payment reduces the balance owed, which leads to a decreasing interest component
over time. Common types include mortgages and auto loans.

Security Provisions and Protective Covenants

Security provisions are measures taken by lenders to protect their interests in case of borrower default.
These provisions may include collateral requirements or asset pledges. Protective covenants are
stipulations that restrict certain borrower actions, like additional debt or asset disposal, to mitigate lender
risk.

Lease Financing

Types of Leases
Leases can be classified into various types, including:
1. Operating Leases: Short-term leases where the lessee pays for using an asset without assuming
ownership.
2. Finance Leases: Long-term leases where the lessee takes on most risks and rewards of ownership,
eventually gaining ownership.
3. Sale and Leaseback: Arrangement where the asset owner sells the asset and leases it back.
4. Capital Lease: Similar to finance leases, used in accounting to show leased assets as owned assets.

Advantages of Leasing to the Lessee

1. Preservation of Capital: Leasing allows businesses to use assets without large upfront expenditures.
2. Tax Benefits: Lease payments may be tax-deductible, reducing taxable income.
3. Flexibility: Leasing offers more flexibility in asset management, allowing upgrades or termination at
lease end.

Disadvantages of Leasing to the Lessee

1. Higher Overall Cost: Leasing may be more costly in the long run compared to purchasing.
2. Limited Control: Lessees have limited control over leased assets.
3. Obligation to Make Payments: Lease payments are mandatory, impacting cash flow even if the asset
becomes obsolete.
Lease-Buy Analysis: The Lessee’s Perspective
Lease-buy analysis involves comparing the cost of leasing with the cost of purchasing, taking into
account factors such as tax impacts, depreciation, cash flow, and asset management. For some assets,
leasing may be advantageous when rapid technological advancements make asset ownership less
appealing.

Accounting for Leases

Under accounting standards, leases are categorized based on lease duration and financial impact. Finance
leases are recorded as assets with corresponding liabilities on the balance sheet. Operating leases are
treated as expenses, showing only payment obligations without reflecting ownership.

Factors Affecting Leasing versus Owning Decisions

1. Cash Flow: Leasing offers lower initial costs but may have higher long-term expenses.
2. Tax Implications: Lease payments are often deductible, but ownership provides depreciation benefits.
3. Control and Maintenance: Ownership allows full control and responsibility for maintenance; leases
often include restrictions.

Evaluation of Lease by Lessor

The lessor evaluates leases based on projected cash flows, residual value, and potential tax benefits. The
goal is to achieve returns that exceed the asset's cost while minimizing risk. Factors considered include
creditworthiness of the lessee, asset depreciation, and potential alternative uses for the asset after lease
termination.

Sources of Value in Leasing

Value in leasing derives from tax benefits, efficient asset usage, residual value at lease end, and risk-
sharing between lessee and lessor. Leasing provides an advantage when assets depreciate quickly or when
ownership offers little additional value to the lessee.

Numerical Problems
Problem 4.1: You are planning to purchase a machinery costing Rs 500,000. Bank interest rate is 10
percent. Loan period is 5 years. Your banker has offered you following options to repay loan:

a. Equal yearly payment. (Rs. 131,898.3)

b. Prepare loan amortization.

c. If bank asks for a down payment of 20 percent of total price, calculate annual installment. (Rs.
105,518.62)

d. How much could you borrow today if you are willing to have a Rs 10,000 monthly payment? (Assume
payment is made at the end of month and the length of the loan remains the same). (Rs. 470,653.73)

Problem 4.2: The Nirmal Company is faced with the decision of whether it should purchase or lease a
new computer. The computer can be leased on five-year contract for Rs 6,000 a year or it can be
purchased for Rs 25,000. The salvage value of the computer after five years is Rs 2,000. The company
uses straight-line depreciation. The discount rate applied is its after-tax cost of debt. The company can
borrow at 15 percent and has a 40 percent marginal tax rate and a 12 percent cost of capital.

a) Calculate the cost of leasing. (Rs. 14,002.92)

b) Calculate cost of purchasing. (Rs. 15,543.13)
c) Should the firm of purchase?

Problem 4.3: Everest Nepal seeks to acquire the use of a machine at the lowest possible cost. The choice
is either to lease one at Rs 6,600 annually or to purchase one of Rs 15,000. The lease payment is payable
at the end of the year. The company's cost of debt is 10 percent, and its tax rate is 40 percent. The
machine has an economic life of five years with no salvage value. The firm uses straight line depreciation
method:

a. Calculate the present value of cost under leasing alternative. (Rs. 16,681.1)
b. Calculate the present value of cost under purchase alternative. (Rs.9945.12)
c. Would you lease or purchase the assets?

Problem 4.4: A Company is trying to decide between leasing and buying a new equipment. The company
can lease the equipment for five years, making annual payments of Rs 16,378 per year or they can buy the
equipment for Rs 50,000. At the end of fifth year, the equipment will have salvage value of Rs 10,000.
The firm's cost of capital is 10 percent with a before tax cost of debt of 8 percent. The company uses
straight-line depreciation and has a 50 percent tax rate.

Analyze whether the company should lease or buy. Use the after-tax cost of debt as a discount factor and
obtain the result using schedules. (Leasing: Rs. 36455.79 and Owning: 23973.59)

Problem 4.5: Himalayan College needs a generator. It can either buy it for Rs 250,000 or lease it from
the company. The lease and purchase terms are as follows:
Leasing: Himalayan College lease under a five-year lease requiring annual end-of-year payments of Rs
62,000.
Purchasing: The generator costs Rs 250,000 and will have a five-year life. The salvage value of generator
is Rs 10,000. The investment tax credit is 10 percent. The annual maintenance expenses are Rs 1,000 per
year (which has been included in lease rent under leasing alternative). The asset will be depreciated under
straight line method for five years. The interest rate on bank loan is 10 percent. The firm is in the 40
percent tax bracket.

a. What is the cost of leasing? (Rs. 156,701.28)

b. What is the cost of owning? (Rs. 139,176.36)
c. Should the college lease or purchase the generator?

Problem 4.6: National Hydropower Company (NHC) needs a drilling machine for construction of a
tunnel. One alternative is to lease the machine on a 4-year guideline contract for a lease payment of Rs
50,000 per year, with payments to be made at the end of each year. Alternatively, NHC could purchase
the machine outright for Rs 200,000, financing the purchase by a bank loan for the net purchase price and
amortizing the loan over a 4-year period at an interest rate of 12 percent per year. The machine falls into
the MACRS 3-year property class. It has a residual value of Rs 20,000, which is the expected market
value after 4 years, when NHC plans to replace the machine irrespective of whether it leases or buys.
NHC has a marginal corporate tax of 35 percent.
a. What is NHC's PV cost of leasing? (Rs. 108,125.08)
b. What is NHC's PV cost of owning? Should the machine be leased or purchased? (Rs. 129,838.9)
c. What are the advantages of leasing over purchasing?

Problem 4.7: FFF Company wishes to acquire a Rs 100,000 multi-facet cutting machine. The machine
has a useful life of 8 years, after which there is no expected salvage value. If it were to lease finance the
machine over 8 years, annual lease payments of Rs 16,000 would be required, payable in advance. The
company also could borrow the money to purchase the asset, falling in the 5-year property class for cost
recovery (depreciation) purposes and the company has a 35 percent tax rate.
What is the present value of cash outflows for each of these alternatives, using the after-tax cost of debt as
the discount rate? Which alternative is preferred? (Rs. 67,449 and Rs. 71,462.97)

Problem 4.8: TATA Company produces industrial machines, which have five-year life. TATA is willing
to either sell the machines for Rs 3,200,000 or to lease them at a rental that yields an after tax return to
TATA of 6 percent - its cost of capital. What is the company’s competitive lease rental rate? Assume
straight-line depreciation, Rs 200,000 salvage value, and an effective corporate tax rate of 40 percent.
(Rs. 906,981)

Problem 4.9: The Delta Company produces industrial machines, which have five-year lives. Delta is
willing to either sell the machines for Rs 300,000 or lease them at a rental that, because of competitive
factors, yields an after-tax return to Delta of 6 percent - its cost of capital. What is the company's
competitive lease-rental rate? (Assume straight-line depreciation, zero salvage value, and an effective
corporate tax rate of 40 percent.) (Rs. 78,698)

b. The Gamma Machine Shop is contemplating the purchase of a machine exactly like those rented by
Delta. The machine will produce net benefits of Rs 100,000 per year. Gamma can buy the machine for Rs
300,000 or rent it from Delta at the competitive lease-rental rate. Gamma's cost of capital is 12 percent, its
cost of debt 10 percent, and T = 40 percent. Which alternative is better for Gamma? How will Gamma's
decision be altered if Delta's cost of capital is 9 percent? (Rs. 198,903)

Problem 4.10: Mountain Mining Company (MMC) must install Rs 1.5 million of new machinery in its
Sholu mine. It can obtain a bank loan for 100 percent of the purchase price, or it can lease the machinery.
Assume that the following facts apply:

1. The machinery, which has a useful life of 4 years, falls into the MACRS 3-year class.
2. Estimated maintenance expenses are Rs 75,000 per year, payable at the beginning of each year.
3. The firm's tax rate is 40 percent.
4. The loan would have an interest rate of 15 percent.
5. The lease terms call for Rs 400,000 payments at the end of each of the next 4 years.
6. Under either the lease or the purchase, the company must pay for insurance, property taxes, and
maintenance.
7. The estimated residual (and salvage) value is Rs 250,000 at the end of 4th year.

What is the NAL of the lease? Should the machinery be leased or purchased? (Rs 108,057)

Problem 4.11: Janakpur Industries must install Rs 1 million of new machinery in its Jaleshwor plant. It
can obtain a bank loan for 100 percent of the required amount. Alternatively, a Jaleshwor investment
banking firm which represents a group of investors believes that it can arrange for a lease financing plan.
Assume that these facts apply:
 1. The equipment falls in the MACRS 3-year class.
2. Estimated maintenance expenses are Rs 50,000 per year.
3. The firm’s tax rate is 34 percent.
4. If the money is borrowed, the bank loan will be at a rate of 14 percent, amortized in 3 equal
installments at the end of each year.
5. The tentative lease terms call for payments of Rs 320,000 at the end of each year for 3 years.
6. Under the proposed lease terms, the lessee must pay for insurance, property taxes, and
maintenance.
7. Janakpur must use the equipment if it is to continue in business, so it will almost certainly want to
acquire the property at the end of the lease. If it does, then under the lease terms it can purchase
the machinery at its fair market value at that time. The best estimate of this market value is Rs
200,000, but it could be much higher or lower under certain circumstances.

To assist management in making the proper lease-versus-buy decision, you are asked to answer the
following questions: (Rs 685,752 and Rs 729,956)

Assuming that the lease can be arranged, should the firm lease or borrow and buy the equipment?
Explain. (Hint: In this situation, the firm plans to use the assets beyond the term of the lease. Thus, the
residual value becomes a cost to leasing in Year 3. Also, there is no Year 3 residual value tax
consequence, as the firm cannot immediately deduct the Year 3 purchase price from taxable income)

Problem 4.12: PB Shipping Company may need dock facilities in Calcutta. It would use the facilities for
4 years in connection with supplying heavy duty equipment and other cargo to the area. The Port of
Calcutta Authority leases the facilities at an annual cost of Rs 200,000, payable at the beginning of each
year. Although the port authority has not stated the implied interest rate embodied in the lease payments,
officials of the company believe a 9 percent rate would be appropriate. Over the 4 years, the company
expects the project to have cash flows of Rs 180,000 in the first year, Rs 250,000 in the second, Rs
320,000 in the third, and Rs 240,000 in the last year. (For simplicity, assume these cash flows are realized
at the end of each of the 4 years.) The project is subject to risk and it has been determined that the
required after-tax rate of return is 18 percent.

Should the company undertake the project and lease the dock facilities or should it reject the project? (Rs.
706,260 and - Rs. 55,616)

Problem 4.13: The Nepal Transportation Company (NTC) has decided to acquire a new computer. One
alternative is to lease the computer on a 4-year contract for a lease payment of Rs 10,000 per year, with
payments to be made at the beginning of each year. The lease would include maintenance. Alternatively,
NTC could purchase the computer outright for Rs 40,000, financing the purchase by a bank loan for the
net purchase price and amortizing the loan over a 4-year period at an interest rate of 10 percent per year.
Under the borrow to purchase arrangement, NTC would have to maintain the computer at a cost of Rs
1,000 per year, payable at year end. The computer falls into the MACRS 3-year class. It has a residual
value of Rs 10,000, which is the expected market value after 4 years, when NTC plans to replace the
computer irrespective of whether it leases or buys. NTC has a marginal rate of 40 percent.

a. Who are the parties involved in a lease contract?

b. What is the NTC’s PV cost of leasing? (Rs 22,869.6)
c. What is the NTC’s PV cost of owning? Should the computer be leased or purchased? (Rs. 23,036.81)
d. The appropriate discount rate for cash flows used in the analysis is the firm's after-tax cost of debt.
Why?