CHAPTER

LEASING

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LEASE

 A LEASE IS A CONTRACT BETWEEN TWO

PARTIES CALLED THE LESSOR AND THE
LESSEE WHEREBY THE LESSOR CONVEYS
TO THE LESSEE IN RETURN FOR RENT THE
RIGHT TO USE AN ASSET FOR AN AGREED
PERIOD OF TIME

 THE RELATIONSHIP BETWEEN THE

LESSOR AND LESSEE IS THAT OF A
BAILOR (lesser) AND BAILEE (lessee)
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LAWS APPLICABLE
 THERE IS NO EXCLUSIVE LAW/
LEGISLATION/ ACT/
REGULATION/DIRECTION TO GOVERN
EQUIPMENT LEASE FINANCING
 ALLIED LEGISLATIONS LIKE CONTRACT
ACT, THE VEHICLES ACT, THE STAMP ACT
AND THE CENTRAL BANK NBFCs
DIRECTIONS CONSTITUTE LEGAL FRAME
WORK
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LEASE - CONCEPT
 A LEASE MAY BE DEFINED AS A
CONTRACTUAL ARRANGEMENT /
TRANSACTION IN WHICH A PARTY
OWNING AN ASSET/EQUIPMENT (LESSOR)
PROVIDES THE ASSET FOR USE TO
ANOTHER / TRANSFER THE RIGHT TO USE
THE EQUIPMENT TO THE USER ( LESSEE)
OVER A CERTAIN /FOR AN AGREED
PERIOD OF TIME FOR CONSIDERATION IN
FORM OF / IN RETURN FOR PERIODIC
PAYMENT ( RENTALS) WITH OR WITHOUT
A FURTHER PAYMENT ( PREMIUM)
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LEASING…
 INVOLVES THE DIVORCE OF OWNERSHIP
FROM THE ECONOMIC USE OF AN ASSET /
EQUIPMENT
 IT IS A CONTRACT IN WHICH A SPECIFIC
EQUIPMENT REQUIRED BY THE LESSEE IS
PURCHASED BY THE LESSOR( FINANCIER)
FROM A MANUFACTURER / VENDOR
SELECTED BY THE LESSEE
 LEASE FINANCING IS THUS, A DEVICE OF
FINANCING OR MONEY LENDING
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LEASING…

 LEASE FINANCING IS ,IN EFFECT, A

CONTRACT OF LENDING MONEY

 THE LESSOR IS THE NOMINAL OWNER OF

THE ASSET AS THE POSSESSION AND
ECONOMIC USE OF THE EQUIPMENT
VESTS IN THE LESSEE

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ESSENTIAL ELEMENTS OF
LEASING
 1. PARTIES TO THE CONTRACT ( LESSOR,
LESSEE, LEASE FINANCIER, LEASE
BROKERS)
 2.ASSET ( SUBJECT MATTER OF A
CONTRACT OF LEASE FINANCING)
 3. OWNERSHIP SEPARATED FROM USER
 4.TERM OF LEASE
 5. LEASE RENTALS ( CONSIDERATION-
BASED ON DEPRECIATION, INTEREST ON
INVESTMENT, REPAIRS …)

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ESSENTIALS…..
 6. MODES OF TERMINATING LEASE
 A. THE LEASE IS RENEWED ON A PERPETUAL
BASIS OR FOR A DEFINITE PERIOD OR
 B.THE ASSET REVERTS TO THE LESSOR OR
 C.THE ASSET REVERTS TO THE LESSOR AND
THE LESSOR SELLS IT TO A THIRD PARTY OR
 D.THE LESSOR SELLS THE ASSET TO THE
LESSEE

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Liabilities of Lessee

 1.Reasonable care ( a man of ordinary

prudence would do to protect his own goods)
 2. Not to make unauthorized use
 3.To return the goods
 4. Not to set up an adverse title
 5. To pay the lease rental
 6.To insure and repair the goods

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Liabilities of Lesser

 1.Delivery of goods
 2. Ensuring the peaceful possession of
goods by lessee
 3. Fitness of goods
 4. To disclose all defects

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MINIMUM LEASE
PAYMENTS
 THE PAYMENTS OVER THE LEASE
TERM THAT THE LESSEE IS OR CAN
BE REQUIRED TO MAKE
( EXCLUDING COSTS FOR SERVICES
AND TAXES TO BE PAID BY AND BE
REIMBURSABLE TO THE LESSOR)
TOGETHER WITH THE RESIDUAL
VALUE
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Rental structures

 1. Equated / Level

 2.Stepped

 3.Ballooned

 4. Deferred
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FAIR VALUE

 THE AMOUNT FOR WHICH AN ASSET

COULD BE EXCHANGED BETWEEN A
KNOWLEDGEABLE WILLING BUYER
AND A KNOWLEDGEABLE WILLING
SELLER

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BALLOON LEASING

 EXPECTED TO HAVE A ZERO

RESIDUAL VALUE AT THE END OF
THE LEASE PERIOD
 SOMETIMES IT MEAN LEASE
RENTALS LOW AT THE
INCEPTION,HIGH DURING THE MID-
YEARS AND LOW DURING THE END

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BIG TICKET LEASE

 A LEASE OF HIGH VALUE ITEMS

SUCH AS AIRCRAFT, SHIPS, POWER
PLANTS ETC..

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OPEN END LEASE

 A LEASE WHICH CONTAINS A

PROVISION FOR THE EXTENSION OF
THE LEASE ON PREDETERMINED
TERMS AFTER THE END OF THE
FIXED PROJECT

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CLOSED END LEASE

 A LEASE WHERE THE PROPERTY

REVERTS TO THE LESSOR AT THE
END OF THE LEASE PERIOD

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DRY LEASE

 LESSEE PAYS THE EXECUTORY

COSTS CONNECTED WITH THE
LEASED ASSET LIKE
INSURANCE,MAINTENANCE,REPAIRS
ETC ( CONTRAST WITH WET LEASE)

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FRONT-LOADED LEASE

 RENTAL PAYMENTS ARE HIGHER IN

INITIAL YEARS,GOING DOWN
TOWARDS THE END ( OPPOSITE OF
BACK LOADED LEASE OR REAR-
ENDED LOADED LEASE)

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LEVEL PAYMENTS

 EQUAL RENTAL PAYMENTS OVER

THE LEASE TENURE

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USEFUL LIFE

 OPERATING LEASE : THE PERIOD

OVER WHICH A FIXED ASSET IS
EXPECTED TO BE USED OR THE
NUMBER OF PRODUCTION ( OR
SIMILAR) UNITS EXPECTED TO BE
OBTAINED
 FINANCE LEASE: THE USEFUL LIFE
OF THE ASSET IS THE LEASE TERM
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RESIDUAL VALUE

 VALUE ESTIMATED AT THE

INCEPTION OF LEASE,OF THE
LEASED ASSET,AT THE EXPIRY OF
THE LEASED TERM

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GROSS INVESTMENT IN
THE LEASE

 THE AGGREGATE OF THE MINIMUM

LEASE PAYMENTS UNDER A
FINANCE LEASE FROM THE STAND
POINT OF THE LESSOR
 ( THE AGGREGATE LEASE RENTALS
AND THE RESIDUAL VALUE)

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PERCENTAGE LEASE

 % LEASE REQUIRES THE LESSEE TO

PAY A FIXED AMOUNT OF RENT FOR
EACH PERIOD PLUS A % OF GROSS
REVENUE RECEIVED DURING THE
PREVIOUS PERIOD.
 SUCH LEASES ARE COMMON IN
REAL ESTATE

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SWAP LEASE

 ALLOWS LEASE TO EXCHANGE THE

EQUIPMENT WHEN THE ORIGINAL
EQUIPMENT GOES FOR A MAJOR
REPAIR. THE LESSOR MAKES
ARRANGEMENT FOR A SWAP

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WRAP LEASE
 A TYPICAL LEASE WHERE THE LESSEE
FURTHER SUB-LEASES THE EQUIPMENT
TO THE END USER ,RETAINING A FEE AND
A SHARE OF THE RESIDUAL .NORMALLY,
THE FIRST LEASE TERM IS LONGER THAN
THE SECOND,TO MAXIMISE THE FIRST
LESSOR’S TAX DEDUCTIONS AND SO IT IS
TERMED AS WRAP LEASE- THE FIRST
LEASE WRAPPING THE SECOND.

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RISK AND REWARD
 RISK REFERS TO THE POSSIBILITY OF
LOSS ARISING ON ACCOUNT OF UNDER
UTILISATION OR TECHNOLOGICAL
OBSOLESCENCE OF THE EQUIPMENT

 REWARD REFERS TO THE INCREMENTAL

NET CASH FLOWS THAT ARE GENERATED
FROM THE USAGE OF EQUIPMENT OVER
ITS ECONOMIC LIFE AND THE
REALISATION OF RESIDUAL VALUE
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TYPES OF LEASE

 1. FINANCIAL LEASE OR CAPITAL LEASE

 2. OPERATING LEASE OR SERVICE LEASE

 3.DIRECT LEASE AND SALE AND LEASE
BACK LEASE
 4. SINGLE INVESTOR AND LEVERAGED
LEASE
 5. DOMESTIC LEASE AND INTERNATIONAL
LEASE
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FINANCIAL LEASE
 IF A LEASE TRANSFERS A SUBSTANTIAL
PART OF THE RISKS AND REWARDS ,IT IS
CALLED FINANCIAL LEASE
 IN INDIA , IF THE LEASE TERM EXCEEDS
75% OF THE USEFUL LIFE OF THE ASSET
OR IF THE PV OF THE MINIMUM LEASE
RENTALS EXCEEDS 90% OF THE FAIR
MARKET VALUE , THE LEASE IS
CLASSIFIED AS FINANCIAL LEASE
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LEASE BEING
CONSIDERED AS F.L
 1. THE LEASE TRANSFERS OWNERSHIP
OF THE ASSET AT THE END OF THE
LEASE TERM
 2.THE LESSEE HAS THE OPTION TO
PURCHASE THE LEASE
 3.THE LEASE TERM IS FOR THE MAJOR
PART OF ECONOMIC LIFE OF THE ASSET
 4.THE PRESENT VALUE OF THE LEASE
PAYMENT CONSTITUTE A SUBSTANTIAL
FAIR VALUE OF THE ASSET
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FINANCIAL LEASE…..

 DURING THE LEASE TERM, THE LESSOR IS

ABLE TO RECOVER HIS CAPITAL OUTLAY
PLUS A RETURN ON HIS INVESTMENT
 LESSOR PLAYS THE ROLE OF A
FINANCIER
 LESSOR HAS NOT BOTHER ABOUT THE
PROPER MAINTEANCE OF THE ASSET-
RESPONSIBILITY OF THE LESSEE

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FINANCIAL LEASE…. TYPES
OF ASSETS INCLUDED

 SHIPS, AIRCRAFTS,RAILWAY WAGONS,

LANDS, BUILDINGS,HEAVY
MACHINERY,DIESEL GENERATING SETS
ETC..
 A F.L WHICH OPERATES OVER THE
ENTIRE ECONOMIC LIFE OF THE
EQUIPMENT IS CALLED FULL PAYOUT
LEASE
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OPERATING LEASE
 THE LESSOR DOES NOT TRANSFER
ALL THE RISKS AND REWARDS
INCIDENTAL TO THE OWNERSHIP OF
THE ASSET ,THE COST OF THE
ASSET NOT FULLY AMORTISED
DURING THE PRIMARY LEASE
PERIOD
 THE LESSOR PROVIDES REPAIR AND
TECHNICAL SERVICE
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OPERATING LEASE…..

 THE LEASE RENTALS INCLUDE A

COST FOR THE “SERVICES”
PROVIDED AND THE LESSOR DOES
NOT DEPEND ON A SINGLE LESSEE
FOR RECOVERY OF HIS COST

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OPERATING LEASE
 IT IS A PERIOD CONTRACT, LESS THAN
THE EXPECTED USEFUL LIFE OF THE
ASSET.
 LESSEE IS ENTITLED TO TERMINATE THE
CONTRACT BY GIVING DUE NOTICE TO
THE LESSOR- CANCELLABLE LEASE
 THE LESSOR RUNS THE RISK OF
OBSOLESCENCE OF THE ASSET

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O.L…..

 THE LESSOR USUALLY PROVIDES

THE RESPONSIBILITY OF INSURING
AND MAINTAINING THE EQUIPMENT,
THEN THE OL IS CALLED “WET
LEASE” AND IF THE LESSEE BEARS IT
IS CALLED “DRY LEASE”

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EG. OF O.L
 1.PROVIDING MOBILE CRANES WITH
OPERATORS
 2.CHARTERING OF AIRCRAFTS AND SHIPS
,INCLUDING THE PROVISION OF CREW,
FUEL AND SUPPORT SERVICES
 3.HIRING OF COMPUTERS WITH
OPERATORS
 4. HIRING A TAXI FOR A PARTICULAR
TRAVEL- DRIVER, PROVISION FOR
MAINTENANCE,FUEL, IMMEDIATE
REPAIRS
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INTERNATIONAL LEASE
 PARTIES ARE DOMICILED IN DIFFERENT
COUNTRIES
 1. IMPORT LEASE ( LESSOR AND LESSEE
DOMICILED IN THE SAME
COUNTRY,SUPPLIER LOCATED IN A
DIFFERENT COUTRY
 2. CROSS BORDER LEASE ( LESSOR AND
LESSEE ARE IN DIFFERENT COUTRIES)
 I.L- COUNTRY RISK AND CURRENCY RISK

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ADVANTAGES OF LEASING –
TO THE LESSEE
 1. FINANCING OF CAPITAL GOODS
 2. ADDITIONAL SOURCE OF FINANCE
 3.LESS COSTLY
 4.OWNERSHIP PRESERVED
 5.AVOIDS CONDITIONALITIES
 6.FLEXIBILITY IN STRUCTURING RENTALS
 7. SIMPLICITY
 8. TAX BENEFITS
 9.OBSOLESCENCE RISK IS AVERTED

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ADVANTAGES TO THE
LESSOR

 1.FULL SECURITY
 2.TAX BENEFITS
 3.HIGH PROFITABILITY
 4.TRADING ON EQUITY
 5.HIGH GROWTH POTENTIAL

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LIMITATIONS OF LEASING
 1. RESTRICTIONS ON USE OF
EQUIPMENT(eg. compulsory insurance)
 2. LIMITATIONS OF FINANCIAL LEASE ( no
express or implied warranty)
 3.LOSS OF RESIDUAL VALUE
 4.CONSEQUENCE OF DEFAULT
 5. UNDERSTATEMENT OF LESSEE’S ASSET
( now foot note to the Balancesheet)
 6.DOUBLE SALES TAX( lessor & lessee)
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CLAUSES IN LEASE
AGREEMENTS
 1. NATURE OF THE LEASE
 2.DESCRIPTION OF THE EQUIPMENT
 3.DELIVERY AND RE-DELIVERY
 4.PERIOD
 5. LEASE RENTALS
 6.USE
 7.TITLE
 8.REPAIRS AND MAINTENANCE
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CLAUSES IN LEASE……
 9. PEACEFUL POSSESSION
 10. CHARGES
 11.INDEMNITY CLAUSE
 12.INSPECTION
 13.PROHIBITION OF SUB-LEASING
 14.EVENTS OF DEFAULT AND REMEDIES
 15. APPLICABLE LAW IN CASE OF
DISPUTE
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CANCELLATION OF NON-
CANCELLABLE LEASE
 1. UPON THE OCCURANCE OF SOME
REMOTE CONTINGENCY
 2. WITH THE PERMISSION OF THE
LESSOR
 3.A FRESH LEASE IS MADE WITH THE
SAME LESSOR
 4.UPON PAYMENT BY THE LESSEE
OF AN ADDITIONAL AMOUNT
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Financial evaluation of
leasing
 THREE STEPS:
 1. APPRAISAL OF THE CLIENTS IN
TERMS OF FINANCIAL STRENGTH
AND CREDIT WORTHINESS
 2. EVALUATION OF THE SECURITY /
COLLATERAL SECURITY OFFERED
 3.FINANCIAL EVALUATION OF THE
PROPOSAL
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FINANCIAL EVALUATION OF
THE PROPOSAL- LESSEE’S
PERSPECTIVE
 A LEASE CAN BE EVALUATED EITHER AS
AN INVESTMENT DECISION OR AS A
FINANCING ALTERNATIVE
 GIVEN AN INVESTMENT DECISION THE
LESSEE HAS TO EVALUATE WHETHER IT
WILL PURCHASE THE ASSET OR ACQUIRE
IT ON LEASE BASIS
 LEASING IS AN ALTERNATIVE TO
BORROWING
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LEASE FINANCING-
EVALUATION
 A LEASE EVALUATION , FROM THE VIEW POINT OF LESSEE
INVOLVES A CHOICE BETWEEN DEBT FINANCING V/S
LEASE FINANCING

 THE DECISION CRITERION USED IS THE NET PRESENT

VALUE OF LEASING ( NPV (L) ) OR NET ADVANTAGE OF
LEASING (NAL)

 THE DISCOUNT RATE USED IS THE MARGINAL COST OF

CAPITAL FOR ALL CASH FLOWS OTHER THAN LEASE
PAYMENTS AND THE TAX COST OF DEBT FOR LEASE
PAYMENTS

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NPV (L) / NAL

 = INVESTMENT COST

 - PV OF LP ( DISCO. BY Kd)

 + PV OF TAX SHIELD OF LP( DISCO.BY Kc)

 - MANAGEMENT FEE

 + PV OF TAX SHIELD ON MGT.FEE (DISCO.Kc)

 - PV OF DEPRE. SHIELD (DISCO.Kc)

 - PV OF INTEREST SHIELD ( DISCO.Kc)

 - PV OF RESIDUAL VALUE ( DISCO.Kc)

 Kc= POST TAX MARGINAL COST OF CAPITAL

 Kd = PRE-TAX COST OF LONG TERM DEBT

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NPV (L) ……

 IF THE NAL / NPV (L) IS POSITIVE ,

THE LEASING ALTERNATIVE IS
USED, OTHERWISE THE
BORROWING ALTERNATIVE WOULD
BE PREFERABLE

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ALTERNATIVE APPROACH
TO EVALUATION
 DETERMINE THE PRESENT VALUES
OF THE CASH OUTFLOWS AFTER
TAXES UNDER THE LEASING AND
THE BORROWING ALTERNATIVES.
 THE DECISION CRITERION IS TO
SELECT THE ALTERNATIVE WITH
THE LOWER PRESENT VALUE OF
CASH OUTFLOWS.
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