LEASE EVALUATION FROM LESSOR’S ANGLE

INTRODUCTION • Computation of break even

– Minimum LR from lessor’s angle which he can accept

– Minimum LR at which NAL from lessor’s point is zero

– Sets the floor price of lease

• Gross yield & pricing of lease

• IRR method of calculating lease

• Lease related risk , assessment of credit risk, product risk & methods of risk management

CASH FLOW STREAM

• Constituent lessor lessee• Initial investment outflow inflow• Management fees inflow outflow• Direct cost outflow ------• LR inflow outflow

• IT liability on LR outflow inflow ( tax shield)

• Tax shield on foregone outflow depreciation inflow

• Sales tax on LR ----- outflow

• Residual value inflow forgone inflow

PRACTICAL PROBLEM • Cost of equipment 33 lacs (inc ST@ 10

%)

• Salvage after 5 yr 10 % of cost

• Initial direct cost 0.3 lac ( front ended)

• Management fees 0.5 lac ( front ended)

• Cost of funds 14%

• Tax rate 46%

• Depreciation 25%

• Five years lease with rental payable annually in arrears

• Calculate Break even rental for 25 % depreciation

SOLUTION

• Equipment cost 33 lacs• PV of LR L * PVIFA (14 , 5 ) = 3.433 L• PV of Tax on LR 3.433 L * 0.46 = 1.579 L• PV of tax shield on depreciation

[8.25 * PVIF (14,1) + 6.19 *PVIF (14 ,2) + 4.64 PVIF (14,3) +2.85 (PVIF (14 ,4 ) + 1.71 PVIF (14,5)] * 0.46 = 8.53 lacs

• PV of direct cost 0.30 lacs• PV of Management Fees 0.50 lacs• PV of tax shield on D.C 0.30 * PVIF (14,1) * 0.46 = 0.12

lacs• PV of tax shield on M.F 0.50 * PVIF (14,1) * 0.46 = 0.20

lacs• PV of salvage value 3.3 * PVIF (14,5) = 1.71 lacs• -33 + 3.433 L -1.579 L + 8.53- 0.30 + 0.50 + 0.12 -0.2 +1.71 = 0• L = 12.21 lacs • If rate of depreciation is more then Break even will come down

PRACTICAL PROBLEM OF BREAK EVEN

• Cost of equipment 1000

• Salvage after 3 yr 8 % of cost

• Cost of funds 14%

• Tax rate 46%

• Depreciation 40%

• Three years lease with rental payable monthly in advance

• Calculate Break even rental

SOLUTION

• Equipment cost 1000• PV of LR 12 L * PVIF A p (14 , 3 )=

=12 L * 1 / d 12 * PVIFA (14,3)=12 L * 1.0743 * 2.322= 29.93 L

• PV of Tax on LR = 12 L * PVIFA (14,3) * 0.46 = 12.82L

• PV of tax shield on [400* PVIF (14,1)+ 240 * PVIF depreciation (14,2) +144 * PVIF (14,3) ] * 0.46

= 290.98• PV of salvage value 1000* 0.08 * PVIF (14,3) = 54• -1000 + 29.93 L -12.82L + 290.98+ 54= 0• L = 38.28 ptpm• If rate of depreciation is 100% • then PV of tax shield of depreciation would be 877 & Break

even will be 4.03 ptpm

ASSESSMENT OF LEASE RELATED RISKS

1. default / credit risk

• Risk of not receiving rentals on schedule

• Most significant

2. Residual value risk

• Decline in residual value of leased equipment

• Full pay out lease can be done

3. Interest rate risk• Change on market rate of interest affecting cost of funds

• Revision of LR on happening of event

4. Purchasing power risk• Reduction in value of LR due to inflation

• Escalation clause can be added in lease agreement

ASSESSMENT OF LEASE RELATED RISKS

5. Political risk

– Change in government fiscal policy viz depreciation or Tax rates

– Add clause for revision of LR

6. Currency & cross border risk – Fluctuation in exchange rate

– Hedging can be done

DEFAULT / CREDIT RISK

DETERMINANTS OF CREDITWORTHINESS

• Character– Integrity, honesty commitment – From informal reports

• Capacity – DE ratio – Interest coverage ratio– Cash flow coverage ratio– Whether lessee is using creative accounting techniques to

manage depreciation , valuation of inventories , accounting for leases , accounting for foreign currency translation ,disclosure of prior period, contingent liabilities & extraordinary items to dress up Financial statements

DETERMINANTS OF CREDITWORTHINESS

• Conditions & competition

– Impact of economic conditions on business of lessee & the competition he is facing

• Collateral– Value maintained by the leased equipment

APPROACHES TO CREDIT RATING • Explicit judgmental approach

– Define set of factors for credit rating & assign weights

• Net worth 40

• Current ratio 35

• Profitability 25

– Give scores on 0 -1 scale to lessee

• Net worth 0.6

• Current ratio 0.8

• Profitability 0.5

– Obtain overall scores

• Net worth 40 * 0.6 = 24

• Current ratio 35 * 0.8 = 28

• Profitability 25 * 0.5 = 12.5

64.5

APPROACHES TO CREDIT RATING

• Statistical approach

– Statistical methods in selection of factors like factor analysis

– Discriminant analysis for distinguishing between good & bad lessee

INCORPORATING CREDIT RISK IN LEASE

AGREEMENT • Increasing LR

• Altering payment schedule

– More front ended pattern of payment

• Reducing duration

– Lease term can be reduced

• Collecting a security deposit

– Forfeit in case of default

• Insisting personal & bank guarantee

• Residual value insurance

GROSS YIELD

• It is defined as compounded rate of return that equates sum of PV of LR & PV of residual value with Investment cost

• PV of LR + PV of residual value + Management fees

= Investment cost + Initial direct cost

• Tax element is not factored

• Hence gross yield (pre tax) is compared with cost of funds (pre tax)

• In practice, cut off rate is pre tax cost of funds plus a profit margin

PRACTICAL PROBLEM OF GROSS YIELD • A company has developed the following table for default risk

classification on basis of gross yieldrisk class required yieldA 19 %B 21%C 24%D 25%

Proposal in hand lease term 5 yearsLR 25 ptpm in advance

1) Credit rating reveals that lessee can be placed in ‘B’, can this proposal be accepted?

2) Assume if 3 months LR is taken in advance & out of which 2 months would be adjusted against payment due for last two months of lease term, will the answer be different?

SOLUTION part 1

• 25 * 12 * PVIFA p (i,5) = 1000• 300 * i / d 12 * PVIFA (i,5) = 1000• i / d 12 * PVIFA (i,5) = 3.333• At i = 0.18, LHS of equation = 1.095 * 3.127 = 3.424• At i = 0.20, LHS of equation = 1.105 * 2.991 = 3.305• Interpolating in range (18,20) we get • i = 0.18 + 0.02 * 3.333 – 3.424

3.305 – 3.424

• = 0.18 + 0.02 * 0.091 0.119

• 0.1953 or 19.53 %• Manager should not accept proposal as in risk class B required

rate of gross yield is 21 %

SOLUTION part 2• (25 * 2) + [25 * 12 * PVIFA p ( i , 4.833) ] = 1000• 4.833 years = 58 months • PVIFA p ( i , 4.833) = 950 / 300 = 3.167• At i= 0.20

1.105 * 2.928 = 3.235• At i= 0.22

1.115 * 2..807 = 3.130• Interpolating in range (20,22) we get • i = 0.20 + 0.02 * 3.167 – 3.235

3.130 – 3.235 • i = 0.20 + 0.02 * 0.068 0.105• 21.29 % , we can accept as gross yield is higher than

required yield for B class

ADD ON YEILD • Calculate add on yield of previous question

• Initial investment = 1000

• Aggregate LR paid

during the period (25 * 60) = 1500

• Aggregate interest charge = 500

over the period

• Average annual interest charge = 100

( 500 / 5 )

• Add on yield = 10 %

( 100 / 1000 * 100)

• This measure of yield provides a distorted picture of true cost of lease to lessee ( 19.53 % compared to 10 %)

GROSS YIELD BASED PRICING • IFSL uses gross yield price approach at pre tax cost of funds

plus 1.3 %.Incremental cost of debt & cost of equity is 15 & 21 %.Gearing ratio is 4 : 1Tax rate is 51.75%.For a lease term of 5 years company collects 1 % management fees upfront & spend 0.5 % of investment as indirect cost upfront & 5% as residual cost after 5 years

• Calculate marginal cost of capital

• Calculate annual LR collected annually in arrears

• Assuming step up pattern by 10 % P.A calculate LR annually in arrears

• Calculate LR monthly payable in advance

• Deferred payment where no LR for 12 months & then monthly in advance

SOLUTION part a & b

• a)

• Marginal cost of equity 21 % = 43.5 %

( 1- 0.5175)

• Marginal cost of capital [4/5 *0.15 + 1/5 *0.435]

• Required gross yield 20.70 % + 1.3 % = 22 %

• b)

• 10 + L * PVIFA (22,5) + 50 * PVIF(22,5) = 1000 + 5

• 10 + 2.864 L + (50 * 0.370) = 1005

• 2.864 L = 976.5

• L = 341

SOLUTION part b& c

• b)

• [ L * PVIF(22,1) + 1.1 L PVIF (22,2) + (1.1)2 L *PVIF(22,3) +

(1.1)3 L *PVIF(22,4) + (1.1)4 L *PVIF(22,5) + 10 + 50 * PVIF (22,5)] = 1000 + 5

• 3.368 L = 976.50

• L = 290 to be charged in first year

• c)

• 12L * PVIFA p ( 22,5) + 10 + 50 * PVIF(22,5) = 1000 + 5

• 38.320L + 10 + 18.5 = 1005

• L = 976.5 / 38.320

• L = 25.48 ptpm

SOLUTION part d

• d)

• 12L * PVIFA p ( 22,4) * PVIF(22,1) + 10 + 50 * PVIF(22,5) = 1000 + 5

• 10 + 27.363 L + 18.5 = 1005

• 27.363 L = 976.5

• L = 35.69 ptpm

IRR OF A LEASE

• Some companies evaluate lease using criterion of IRR

• It is that rate of interest at which the NAL is zero

• Lease accepted only of IRR > marginal cost of capital

PRACTICAL PROBLEM OF IRR

• Target debt equity ratio 4 : 1

• Cost of debt 18%

• Cost of equity 24%

• Tax 46%

• Depreciation 40%

• Net salvage value ignore

• Find IRR for lease proposal

• Should it be accepted

SOLUTION

• 4/5 * 0.18 * 0.54 + 1/5 * 0.24 = 12.58%

• Equipment cost 1000

• PV of LR 25 * 12 * PVIFA p (i , 5 )

300 * i /d 12 * PVIFA (i , 5 )

• PV of Tax on LR 25 * 12 * 0.46 * PVIFA (i , 5 )

138 * PVIFA (i , 5 )

• PV of tax shield on depreciation

[400 * PVIF (i,1) +240 *PVIF (i ,2) + 144 PVIF (i,3) +86.4 PVIF (i ,4 ) + 51.84 PVIF (i,5)] * 0.46

• - A + B – C + d = 0

• Lease is to be accepted if IRR > marginal cost of capital

NEGOTIATING LEASE RENTAL • LB1 = break even LR of lessor ( lower limit)

• LB = break even of LR of lessee( upper limit)

• As long as rental is between LB1 & LB both lessor & lessee will enjoy positive NAL

• Cost of equipment 30 lacs

• Rate of depreciation 40%

• Useful life 5 years

• Lessee gets proposal of 25 ptpm advance monthly from lessor

• Marginal cost of debt ,capital & tax rate for lessee is 17 (pre tax), 14 & 46%

• Lessor requires a post rate return of 13 % on portfolio

• Determine Break even for lessee & lessor

• Comment upon spread between two break even

SOLUTION

• LESSEE

• Equipment cost 1000

• PV of LR 12 LB * PVIF A p (17 , 5 )=

=12 LB * 1 / d 12 * PVIFA (17,5)

=12 LB * 1.09 * 3.199

= 41.84 LB

• PV of Tax on LR = 12 LB * PVIFA (14,5) * 0.46

= 18.95LB

• PV of tax shield foregone [400* PVIF (14,1)+ 240 * PVIF (14,2) on depreciation +144 * PVIF (14,3) + 86.4 * PVIF

(14,4) + 51.84 * PVIF( 14,5) ] * 0.46

= 326.88

SOLUTION contd.• PV of interest tax =[6.03LB*PVIF (14,1)+5.02LB*PVIF(14,2)

shield ( on + 3.83LB * PVIF (14,3)+ 2.44LB * PVIF displaced debt ) (14,4) + 0.84 LB * PVIF (14,5)] * 0.46 = 6.26LB

• ( DISPLACED ) DEBT AMORTISATION SCHEDULEYEAR LOAN O/S INTT PRINCIPAL RENTAL1 41.84LB 5.97LB 6.03LB 12LB2 35.87LB 6.98LB 5.02LB 12LB3 28.89LB 8.17LB 3.83LB 12LB4 20.72LB 9.56LB 2.44LB 12LB5 11.16LB 11.16LB 0.84LB 12LB INTEREST CALCULATION ON DEBT AMORTISATION SCHEDULE

• 12LB * 1.0899 – 12LB = 1.08LB• Amount outstanding at beginning * 0.17 – 1.08LB

SOLUTION contd.

• 1000 – 41.84 LB + 18.95 LB – 326.88 -6.26LB = 0• LB = 23.11 ptpm • LESSOR • Equipment cost 1000• PV of LR =12 LB1 * PVIF A p (13 , 5 )=

=12 LB1 * 1 / d 12 * PVIFA (13,5)=12 LB1 * 1.0691 * 3.517= 45.12 LB1

• PV of Tax on LR 12 LB1 * PVIFA (13,5) * 0.46 = 19.41LB1

• PV of tax shield foregone = [400* PVIF (13,1)+ 240 * PVIF on depreciation (13,2) +144 * PVIF (13,3) + 86.4 *

PVIF (13,4) + 51.84 * PVIF( 13,5) ] * 0.46

= 332.50

SOLUTION contd.

• - 1000 + 45.12 LB1 – 19.41 LB1 + 332.50 = 0

• LB1 =25.96 ptpm

• INFERENCE

• Maximum LR lessee would pay on 30 lacs would be 0.69 lacs ptpm (23.11 / 1000 * 30) while minimum LR lessor would accept Rs 0.78 lacs ptpm ( 25.96 / 1000 * 30).

• There is no positive spread & bargaining area doesn’t exist