2003BA011 MERCHANT BANKING AND FINANCIAL SERVICES

UNIT III

MERGERS AND ACQUISITIONS

Mergers and Acquisitions (M&A) as forms of business combination are increasingly being used for
undertaking restructuring of corporate enterprises the world over. In fact, the corporate world is in the grip
of merger-mania (mega mergers and hostile takeovers).

Mergers

A type of business combination where two or more firms amalgamate into one single firm is known as a
merger. In a merger, one or more companies may merge with an existing company or they may combine to
form a new company. In India mergers and amalgamations are used interchangeably.

In the wider sense, merger includes consolidation, amalgamation, absorption and takeover. It signifies the
transfer of all assets and liabilities of one or more existing companies to another existing or new company.
The main purpose of merges is to achieve the advantage of fusion and synergy through expansion and
diversification.

Steps IN M & A: Following are the steps involved in M&A

▪ Review of Objectives
▪ Data for Analysis
▪ Analysis of Information
▪ Fixing Price\Finding Merger Value
Forms of Merger

Merger takes place in the following forms:

1. Merger through absorption

2. Merger through consolidation
Major Issues Of M&A In India

Business combinations and re-structuring in the form of merger, etc. have been attempted to face the
challenge of increasing competition and to achieve synergy in business operations. The major issues of
M&A are as follows:

▪ Depreciation
▪ R&D Expenditure
▪ Tax Exemption
▪ Carry Forward Losses

Related Connotations

There are terms that sound relative to merger/amalgamation. These include acquisition and takeover.

Acquisition:
The term ‘acquisition’ is used to refer to the act of acquiring of ownership right in the property and assets
of another company and thereby bringing about change in the management of the acquiring company.
Acquisition could happen in any of the following ways:

1. Entering into an agreement with a person or persons holding controlling interest in the other
company.
2. Subscribing new shares issued by the other company in the open market
3. Purchasing shares of the other company at a stock exchange
4. Making an offer to buy the shares of other company, to the existing shareholders of that company.

Takeover: Another term associated with merger is ‘takeover’. In the case of a takeover, one company
obtains control over management of another company. Under both acquisition and takeover, it is possible
for a company to have effective control over another company even by holding minority ownership.

An example, of acquisition in Mahindra and Mahindra Ltd., a leading manufacturer of jeeps and tractors,
acquiring equity stake of Allwyn Nissan Ltd. On the other hand, the acquisition of Shaw Wallace, Dunlop,
Mather and Platt and Hindustan Dorr Oliver by Chhabrias and Ashok Leyland by Hindujas, etc are the
examples of ‘hostile takeovers’ that have happened in the post liberalization era of the Indian financial
sector.

Hostile Takeover

Where in a merger one firm acquires another firm without the knowledge and consent of the management
of the target firm, it takes the form of a ‘hostile takeover’. The acquiring firm makes and unilateral
attempt to gain a controlling interest in the target firm, by purchasing shares of the later firm directly in
the open (stock) market.

TYPES OF MERGER:
Mergers are of different types as mentioned below:

1. Horizontal merger
2. Vertical merger
3. Diagonal merger
4. Forward merger
5. Reverse merger
6. Forward Triangular merger
7. Reverse Triangular merger
8. Conglomerate merger
9. Congeneric merger
10. Negotiated merger
11. Arranged merger
12. Agreed merger
13. Unopposed merger
14. Defended merger
15. Competitive merger
16. Tender offer

SERVICES RELATING TO THE PORTFOLIO MANAGERS UNDER THE SEBI

REGULATION.
Portfolio Management Services:
Preserving and growing capital is as hard as earning it. Knowing what one want is as important as
achieving those goals. Assessing one‘s risk profile and aligning potential returns for the risk assumed
from various investment options is the crucial task..

Portfolio and Management Services: A list of all those services and facilities that are provided by a
portfolio manager to its clients, relating to the management and administration of portfolio of securities or
the funds of the client, is referred to as portfolio management services. The term portfolio means the total
holdings of securities belonging to any person.

Portfolio Manager: According to SEBI, Portfolio Manager means any person who pursuant to a contract
or arrangement with a client, advises or directs or undertakes on behalf of the client (whether as a
discretionary portfolio manager or otherwise) the management or administration of a portfolio of
securities or the funds of the client, as the case may be.

Discretionary Portfolio Manager: According to SEBI, discretionary portfolio manager means a

portfolio manager who exercises or may, under a contract relating to portfolio management, exercises any
degree of discretion as to the investments or management of the portfolio of securities or the funds of the
client, as the case may be.

Objectives of Portfolio Management

➢ Provide long term capital appreciation with lower volatility, compared to the broad equity
markets.
➢ Takes long positions in the cash market and short positions in the index futures markets.
➢ Invests in the model portfolios thus downside the risk by selling index futures in the derivatives
market.

Functions: The objective of portfolio management is to develop a portfolio that has a maximum return at
whatever level of risk the investor deems appropriate.

a) Risk Diversification
b) Asset Allocation
c) Bets Estimation
d) Rebalancing Portfolios

CREDIT SYNDICATION

Credit syndication services are services rendered by the merchant bankers in the form of organizing and
procuring the financial facilities form financial institutions, banks, or other lending agencies. Financing
arranged on behalf of the client for meeting both fixed capital as well as working capital requirements is
known as loan syndication service‘

Credit Syndication Services: Merchant bankers provide various services towards syndication of loans.
The services may be either loan sought for long term fixed capital or of working capital funds. They are
discussed in detail.

Objectives: Arranging medium and long term funds for long term fixed capital and working capital fund
needs.

Scope: The scope of syndicated loan services as provided by merchant bankers include identifying the
sources of finance, approaching these sources, applying for the credit, and sanction and disbursal of loans
to the clients.

1) General Information
2) Promoter information
3) Company information
4) Project profile information
5) Project cost information
6) Project financing information
7) Project marketing information
8) Cash flow information

Making Application

The merchant banker files the duly filled-in application in a manner as desired by the term-lending
institution. While presenting the application, it is incumbent on the part of the merchant banker to ensure
that all the required formalities have been complied with.

Merchant banker provides advice in the preparation of project/feasibility report and the market
survey report, and the financial projections relating to the project.

1. Technical Appraisal:
2. Ecological Appraisal
3. Financial Appraisal
4. Promoters Contribution
5. Economic Appraisal
6. Commercial Appraisal
7. Managerial Appraisal
8. Arrangement of Loan Sanction
9. Compliance for Loan Disbursement
10. Compliance with Memorandum and the Articles
(b) Statutory Compliance

In addition, compliance is also called for with regard to the provisions constrained in various enactments
concerning the management and regulation of joint stock companies in India. Some of these enactments
include Companies Act, 1956, Industries (Development and Regulation) Act, 1951, Foreign Exchange
Regulation Act, 1973, Securities Contracts (Regulation) Act, 1956, The Foreign Trade (Development and
Regulation) Act, 1992, and Income-Tax Act, 1961.

Documentation and Creation of Security

An important function of a merchant banker is to create an adequate documentation of security by working

closely with the lead financial institution, so as to ensure quicker disbursement of loan. The type of
documents to be prepared and executed by the merchant banker will be as per the requirements of the lead
financial institution. Depending on the loan type, the merchant banker executes bridge loan document or
interim loan document.

Pre–Disbursement Compliance
This function is aimed at merchant bankers assisting the borrowing unit in the withdrawal of the loan
amount from the financial institution. This done with additional compliance of formalities of provision of
information and documentation. Some of the pre-disbursement conditions that require compliance by the
merchant banker are documentation.

CREDIT RATING

Features of Credit Rating

1. Credit rating is an expression of opinion of the credit agency about the risk of a security. This
opinion is subject to change over the life of the security.
2. Credit rating indicates relative grading of risk in a security. Risk quality is expressed on a
comparative basis.
3. Credit rating is revealed through symbols such as ‘AAA’, ‘AA’, etc.
4. The ratings are instrument specific’. It can differ from various instruments of the same company.
5. Rating being the opinions or perceptions of the rating agency, there could be a difference in the
ratings of the same instruments by different agencies.
6. Rating is reflecting the relative credit risk; it does not reflect other investment risks that arise due
to changes in the market conditions.
7. Credit rating is not an investment recommendation. It indicates just one aspect of investment,
namely, risk. Other aspects like yield, risk preference of investor, etc. are not considered.
8. Credit rating is not a one-time task that is over with the assignment of ratings. It is a continuous
process. The ratings assigned are subject to surveillance and if conditions change, the rating may
be revived.
Types of Credit Rating

We have seen the various rating symbols for different categories of the debt instruments. We can also
classify credit rating as types of credit rating which are based on different securities. These are:

1. Equity rating
2. Bond rating
3. Promissory note rating
4. Commercial paper rating
5. Sovereign rating.

Credit Rating Companies in India

➢ Credit rating companies were started in India during the late 1980s.
➢ Credit Rating Information Services of India Ltd (CRISIL) was started in 1988 as a subsidiary of
ICICI. Information
➢ Credit Rating Services Ltd., (ICRA) was started in 1990, which is a subsidiary of IDBI.
➢ Credit Analysis and Research Ltd. (CARE) were started In 1993.

MUTUAL FUND

A mutual fund is an institution that pools the savings of small investors for investment in capital market
and money market securities. The mutual fund invests in diversified securities so as to reduce the
investment risks.

Objectives: Mutual funds came into existence in order to attract the savings of lower and middle income
group people and give them the benefit of corporate profits by distributing attractive dividends at the end
of the year. Mutual funds cater the different types of customers who are interested in

(a) fixed income or

(b) a higher return for investment or

(c) who is growth oriented.

The Association of Mutual Funds in India (AMFI) defines a mutual fund as “a trust that pools the savings
of a number of investors who share a common financial goal”

Mutual Funds set up in India: The structure of mutual fund operations in India envisages a three tier
establishment namely:

1. A Sponsor institution to promote the fund

2. A team of Trustees to oversee the operations and to provide checks for the efficient, profitable and
transparent operations of the fund and
3. An Asset Management Company is to actually deal with the fund and sponsoring Institution.
4. The Company which sets up the Mutual Fund is called the sponsor. The SEBI has laid down certain
criteria to be met by the sponsor.
5. These criteria mainly deal with adequate experience, good past tract record, net worth etc.
Trustees: Trustees are people with long experience and good integrity in their respective fields. They carry
the crucial responsibility of safeguarding the interest of investors. For this purpose, they monitor the
operations of the different schemes. They have wide ranging powers and they can even dismiss Asset
Management Companies with the approval of the SEBI.

Asset Management Company (AMC): The AMC actually manages the funds of the various schemes.
The AMC employs a large number of professionals to make investments, carry out research and to do
agent and investor servicing. In fact, the success of any Mutual Fund depends upon the efficiency of this
AMC. The AMC submits a quarterly report on the functioning of the mutual fund to the trustees who will
guide and control the AMC.

Types of Mutual Fund Schemes

By Structure

• Open-ended scheme
• Close-ended scheme
• Interval scheme
By Investment Objectives

• Growth scheme
• Income scheme
• Balanced scheme
• Money market scheme
Other Schemes

• Tax saving scheme

• Index scheme
• Sectoral scheme
• ETFs
• FoF
• Gilt fund, etc
By Geographic location

• Domestic scheme
• Offshore scheme
Mutual Funds set up in India: The structure of mutual fund operations in India envisages a three tier
establishment namely:

1. A Sponsor institution to promote the fund

2. A team of Trustees to oversee the operations and to provide checks for the efficient, profitable and
transparent operations of the fund and
3. An Asset Management Company is to actually deal with the fund and sponsoring Institution.
4. The Company which sets up the Mutual Fund is called the sponsor. The SEBI has laid down certain
criteria to be met by the sponsor.
5. These criteria mainly deal with adequate experience, good past tract record, net worth etc.
BUSINESS VALUATION

The basic valuation methods of holdings by the Mutual funds should be done by keeping in view the
following elements:

1. For listed securities – take last sale price quoted in the stock exchange dealing list
2. For OTCEI securities – take bid/ask price as may be relevant on case to case basis
3. Trustees may determine market value at a reasonable price as per current market at which the
investors would buy at fairly reasonable rate.
4. For short term investments the basis of valuation should be the amortized cost.

Net Asset Value (NAV): NAV is another parameter used to measure the operational efficiency of mutual
funds. The intrinsic value of a unit under a particular scheme is referred to as the ‘NAV’ of the scheme.
The value gives an idea of the amount that may be obtained by the unit holder on its sale to the mutual fund
company. NAV of a unit is calculated as follows:

NAV per unit = (TMV – CL) ÷SU

Where,

TMV = Total market value of investment portfolio + the written down value of fixed
assets + the cost value of other current assets

CL = Current liabilities

SU = Number of outstanding units in that scheme

For the purpose of determining the NAV, the scheme of accounting practices are prescribed by the SEBI
regulations of 1996 should be followed.

Calculation of NAV:

The NAV calculation should include the following elements for open end funds.

1. Investment at value recorded on first business day after trade transaction.

 2. Changes in outstanding shares on first business day after trade transaction.

3. Dividend and distribution to shareholder ex-date.

4. Expenses (estimated and accrued to date of calculation)

5. Dividends receipts from investments ex-date

6. Interest and other income (estimated and accrued to date of calculation)

7. Other assets /organization costs.

Evaluating Mutual Funds: In order that mutual fund managers act in a judicious manner so as to bring
about ultimate beneficial consequences to the investing community, it is essential that the performance of
such funds is evaluated. Such an appraisal would help the funds compare themselves with other funds,
besides being a potential source of information to the present and prospective investors, especially the small
investors.

Treynor Model: Jack Treynor evolved this model, which can be used to calculate the return per unit of
risk. This is done by assuming that all investors averse to risk would like to maximize this value. The
performance measure is calculated as follows:

PM = [Ari – Arf] ÷ βt

Where,

PM = The Treynor portfolio performance measure for the period

Ari = Average rate of return for portfolio ‘i’ during a period

Arf = Average rate of return on risk free investment during the period

βt = Slop of portfolio ‘i’ characteristic line which represents the portfolio

relative volatility and it systematic risk.

A positive measure show a superior, risk adjusted performance of a fund

Sharpe Model: William F.Sharpe developed this model in 1966. It measures the total risk, not merely
systematic risk (as in Treynor model). The relevant performance measure is computed as follows:

PM = [Ari – Arf] ÷ Nt

Where,

Nt = Standard deviation of rate of returns for the portfolio for the period.

A positive performance measure value is indicative of good performance.

 UNIT IV

LEASING
According to the Institute of Chartered Accountants of India, “A lease is an agreement whereby the lessor
conveys to the lessee, in return for rent, the right to use an asset for an agreed period of time. Lessor is a
person who conveys to another person (lessee) the right to use an asset in consideration of payment of
periodical rental, under a lease agreement. Lessee is a person who obtains from the lessor, the right to use
the asset for a periodical rental payment for an agreed period of time”.

A financing arrangement that provides a firm with the advantage of using an asset without owing, it may
be termed as ‘leasing’.

Leasing: It is a contract by which one party conveys land, property, services etc., to another for a specified
time.

Definition: The Transfer of Property Act, 1882 (as amended in 1952) describes Lease as follows “A Lease
of the movable property is a transfer of a right to enjoy such property, made for a certain time, express of
implied, or in perpetuity, inconsideration of a price paid or promised or of money, a share of crops, service
or any other things of value, to be rendered periodically or on specified occasions to the transferor by the
transferee, who accepts the transfer on such terms.”
o The transferor is called the lessor
o The transferee is called the lessee
o The price is called the premium
The money, share, service or other thing to be rendered is called the rent.

HIRE PURCHASING

A transaction of finance whereby goods are bought and sold as per the terms and conditions specified below
is known as ‘hire purchase finance’.

a. Payment of periodic installments

b. Immediate possession of goods by the buyer
c. Ownership of goods remaining with the vendor until the payment of the last installment
d. Vendor’s right to repossess the goods in the event of default committed by the buyer
e. Treatment of each installment as hire charge till the payment of the last installment
According to Hire Purchase Act of 1972, the term ‘hire purchase’ is defined as “an agreement under which
goods are let on hire and under which the hirer has an option to purchase them in accordance with the terms
of the agreement and includes an agreement under which:

i. Possession of goods is delivered by the owner thereof to a person on the condition that such
person pays the agreed amount in periodic payments
ii. The property of the goods is to pass to such a person on the payment of the last of such
installment
iii. Such a person has a right to terminate the agreement any time before the property so passes.”

CLASSIFICATION OF LEASING:
1. Finance Lease and Operating Lease
2. Sale and Lease Back and Direct Lease
3. Single Investor Lease and Leveraged Lease
4. Domestic Lease and International Lease
Finance Lease: A lease is defined as a finance lease if it transfers a substantial part of the risks and rewards
associated with ownership from the lessor to the lessee.

Operating Lease: The International Accounting Standard Committee defines operating lease as “any lease
other than a finance lease”.

Sale and Lease Back: In the case of sale and lease back, the owner of equipment sells it to a leasing
company, which, in turn, lease it back to the seller of the equipment, who then becomes the lessee. The
Lease Back‘ arrangement in this transaction can be in the form of either a finance lease or an operating
lease e.g., the sale and lease back of safe deposit vaults practiced by commercial banks.

Direct Lease: It is defined as any lease, which is not a sale and lease back transaction. A direct lease can
be of two types: (i) Bipartite lease, and (ii) Tripartite Lease.

Single Investor Lease: The entire investment is funded by the lessor by arriving at a judicious mix of debt
and equity. The debt funds raised by the leasing company are without recourse to the lessee, i.e., in the
event of the default by the leasing company on its debt-servicing obligation, the lender cannot demand
payment from the lessee.

Leveraged Lease: It is a lease which is leveraged through a trustee. The leasing company invests in
equipment by borrowing large investments with full recourse to the lessee without any recourse to it. The
lender (loan participant) gets an assignment of the lease and enjoys benefit of the rentals to be paid by the
lessee and a first mortgage on the leased assets. This transaction is routed through the trustee to take care
of the lender and the lessee.

Domestic Lease and International Lease: In domestic lease, all the parties to the lease
transaction i.e., the equipment supplier, lessor and lessee are domiciled in the same country. An
international lease transaction pre-supposes: An understanding of the political and economic
climate; and As a result international lease is exposed to country risk and currency risk

DISTINGUISH THE CHARACTERISTICS BETWEEN FINANCIAL LEASE AND

OPERATING LEASE.
Characteristics Financial Lease Operating Lease

Specificity The asset leased out is use-specific The asset leased out may be used
for the lessee commonly by a number of users in
sequence

Ownership Risks The lessee bears the risks and The risks and rewards associated
rewards associated with the use of with the use of the asset leased is
the asset leased; the lessor is simply borne by the lessor and the lessee is
the legal owner of the asset simply provided with the use of the
asset for a certain period time

Obsolescence Risk The lessee bears the risks of The lessor bears the risks of
obsolescence obsolescence

Cancelability The lease cannot be cancelled by The lease can be cancelled at the
either of the parties. The lessor is option of the lessee and the lessor
does not have the difficulty of
 rather interested in rental and not in leasing the same asset to other
the asset willing lessees

Lease Period The lease period usually coincides Lease period is generally small, as
with the life of the asset and may be the lessor intends to lease the same
broken into primary and secondary asset several times to various users
period

Maintenance The cost of repairs and maintenance The cost of repairs and maintenance
are borne by the lessee; the lessor is are borne by the lessor.
merely a financier with the lease.

Lessor’s Service As the lessor is just a financial The lessor is specialized in handling
institution, it does not render any and operating the particular asset
specialized service in connection and usually provides specialized
with the lease services

Pay-out It is a full pay-out lease, where a It is usually a non-pay out lease, as

single lease repays the cost of the the lessor is in the business of
asset, together with the interest leasing the asset t various users
several times

Advantages of Leasing

Leasing as a financial service offers the following potential advantages both to the lessor and lessee.

➢ Advantages to Lessor
1. Stable business
2. Wider distribution
3. Sale of supplies
4. Second-hand market
5. Tax-benefits
6. Absorbing obsolescence risks
7. Fillip to capital market
8. Easy finance

➢ Advantages to Lessee
1. Efficient use of funds
2. Cheaper source
3. Flexible source
4. Enhanced borrowing capacity
5. Off-balance sheet financing
6. Tax benefits
7. Favorable terms
8. Guards against obsolescence
9. Avoidance of initial cash outlay
10. Better liquidity

RIGHTS AVAILABLE TO A HIRER UNDER THE HIRE PURCHASE FINANCE AGREEMENT.

Hire Purchase Agreement
 o A Hire Purchase Agreement is an agreement between the seller and the buyer, where the ownership
of goods does not pass to the buyer until he pays the last installment. There are two parties to the
hire purchase agreement.
o The hire vendor, who is the seller and the other, is the hire purchaser, the buyer.
o The purchaser has to make a down payment of 20 to 25% of the cost and the remaining amount has
to be paid in equal monthly installments.
o In the case of a Deposit linked plan, the hire purchaser has to invest a fixed amount as fixed deposits
in the finance company which is returned together with interest after the payment of the last
installment.

Parties to the Hire Purchase Contract

There are two parties in a hire purchase contract:
1) The intending seller
2) The intending purchaser or the hirer

Tripartite Agreement:
(1) Seller
(2) Financier
(3) Hirer/Purchaser
Rights of Hirer

The Hire Purchase Act of 1972 provides the following rights to the hirer:

➢ Right to Protection
➢ Right to Notice
➢ Right to Repossession
➢ Right of Statement
➢ Right to Excess Amount
Rights of Interest

The type of interest rates popularly used in hire purchase financing is as follows:

➢ Add-on Rate of Interest

➢ Flat Rate of Interest
➢ Effective Rate of Interest

DIFFERENCE BETWEEN THE LEASING AND HIRE PURCHASE

Characteristics Lease Financing HP Financing

Ownership Ownership of the property lies with the Ownership of the property is transferred to the
finance company, the lessor and it is hirer on the payment of the last installment
never transferred to the lessee, the user

Depreciation Lessor and not the lessee, is entitled to The hirer (owner) is entitled to claim
claim depreciation tax shield depreciation tax shield

Capitalization Capitalization of the asset is done in the Capitalization of the asset is done in the books of
books of the lessor, the leasing company the hirer

Payments The entire lease payments are eligible for Only the hire-interest is eligible for tax
tax computation in the books of the lessee computation in the books of the hirer
 Salvage Value The lessor and not the lessee, has the right The hirer can claim benefit of salvage value as
to claim the benefit of salvage value the prospective owner of the asset

Magnitude Leasing is used as a source of finance, Hire purchase is used as a source of finance,
usually for acquiring high cost assets usually for acquiring relatively low cost assets
such as machinery, ships airplanes, etc. such as automobiles, office equipment, etc.

Down Payment No down payment is required for Down payment is required to be made for
acquiring the use of leased assets acquiring the asset and there is a margin
maintained to the extent of 20-25 percent

Reporting In the books of the lessee, leased assets The asset bought on hire purchase will be shown
are disclosed by way of a note only as an asset, and the amount of installments
payable to the lessor as a liability

Maintenance of Whereas the lessee has to maintain the It is the hirer’s responsibility to ensure the
Asset lease asset in the case of financial lease, maintenance of the asset bought
upkeep is the responsibility of the lessor
in the case of operating lease

Suitability It is not suitable for the low-capital It is highly suitable for the low-capital
enterprises which desire to show a strong enterprises which need to show a strong asset
asset position in their balance sheets position in their balance sheets

Nature of Asset An asset given on lease by a leasing The hire vendor normally shows the asset let
company is considered as the fixed asset under HP either stock in trade or as receivables
of the lessor

Receipts All receipts from the lessee is taken into Only the interest portion is taken into the hire-
the lessor’s profit & loss account vendor’s profit & loss account

Income Lessor’s income declines as the In the case of HP transactions, finance charges
investment outstanding in the lease are allocated to the HP period equally
declines

FINANCIAL EVALUATION

FINANCIAL EVALUATION

Financial Evaluation is an evaluation by the hirer of the desirability for lease and hire purchase. The hirer
makes decision based on the Present Value of Net Cash Outflow. The decision is considered favourable
when the PV of Net Cash Outflow under Hire Purchase is less than the PV of Net cash Outflow under
leasing.
Tax implication
  A hire purchaser can claim the benefits by claiming depreciation on the goods which are
used in his business.
 Such tax benefits are applicable to sole trader, partnership firms, as well as Joint Hindu
firms.
Overall Financial implications
 For Lessee
◦ Tax shield on lease rentals is available as business expenditure
◦ Depreciation tax shield is not available
 For Lessor
◦ Depreciation tax shield is available
◦ Tax shield on lease rentals is not available as business expenditure
Evaluation of Hire Purchase Proposal
 Methods of Interest calculation:
◦ Effective rate of interest or annual percentage rate method
◦ Sum-of-years digits method
◦ Straight-line method
Effective rate of interest
 It is a method of interest calculation where the effective rate of interest is determined by
the popular ‘IRR’ technique.
Evaluation of Leasing proposals
 Leases are evaluated by both the lessee and the lessor.
 The lessee must determine whether leasing an asset is less costly than buying the asset.
 A decision can be made by evaluating both the leasing and buying alternatives.
 These are referred to as ‘lease or buy decision’.
Lease Vs Buy Decision by using NPV
 The basic philosophy of the concept is to compare the expected benefits with the
investment outlay and see whether the NPV of the benefit are greater than the cost.
Lease Evaluation: lessor’s point of view
 For the lessors, leasing business is an investment of funds and therefore they expect a fair
return on the funds invested.
Loan repayment schedule
 It is a schedule that shows the calculations regarding annual installments, annual
principal repaid and the annual interest paid by the lessor.
Steady Principal Reduction method
Under this method, the total payment of the installment amount will keep diminishing every year.
Steady payment method
 Annual Installment amount = Amount borrowed/Relevant Annuity factor
Balloon Payment Method
 Under this method, firms pay smaller amounts at the beginning and progressively larger
amounts, in later stages of the loan period.
The level rental plan
 It is a straight lease which obligates a firm to make a series of identical payments over the
service life of the asset.

Lease Vs. Hire Purchase Evaluation: The hirer makes the evaluation on the desirability for lease and HP.
The considered hire makes a decision based on the PV of net cash outflow. The decision for HP is
considered favourable where the PV of net cash outflow under HP is less than the PV of net cash under
leasing.
STEPS
Following are the steps involved:

Step 1: Calculate annual interest amount

Step 2: Find Principal amount outstanding at the beginning of each year

= Total outstanding principal – principal paid in the previous year

Step 3: Find Principal paid the previous year = Annual installment amount – Annual interest

Step 4: Find Annual ITS = Annual interest × Tax rate

Step 5: Find Depreciation

Step 6: Find Annual DTS = Annual depreciation × Tax rate

Step 7: Find Total TS = Step 4 + Step 6

Step 8: Find Annual installment amount = Total HP amount + [HP amount× Flat rate of interest] ÷ No of
HP years

Step 9: Find PV of salvage value of asset = SV × PVF ty = Terminal year ; k = Cost of capital

Step 10: Find Net cash flow of HP = Step 8 – Step 7

Step 11: Find PV of net cash outflow of HP at the appropriate discount rate

Step 12: Find Total PV net cash outflow of HP = Step 11 – Step 9

Step 13: Find Tax shield on annual lease rentals = Annual Lease rental × Tax rate

Step 14: Find Net cash outflow of Leasing = [Annual lease rental – Step 13]

Step 15: Find Total PV of net cash outflow of Leasing at the appropriate discount rate

= Net cash outflow of Leasing × PVAF

nk = number of lease years at a ‘K’ interest rate

Step 16: Make a decision: HP is desirable if total PV of net cash outflow of HP is less than that of
leasing
Methods of Interest Calculation

(All methods assume annual payment at the end of the year)

a) Effective rate of interest or annual percentage rate method

b) Sum-of-years digits method
c) Straight-line method

Effective Rate of Interest (ERI): Effective Rate of Interest (ERI) method, also known as Annual
Percentage rate Method, is a method of interest calculation where the effective rate of interest is determined
by the popular ‘IRR’ technique. Accordingly, effective rate of interest is that rate of interest, which equates
the PV of all future annual instalment payments, with the HP principal payable at the beginning of the hire
purchase contract. The HP principal payable is the excess of the cost of the asset hire-purchased, over and
above the down payment made.

Following are the steps involved in the determination of ERI:

Step 1: Find HP Principal = Cost of Asset – Down Payment

Step 2: Find Total Interest Amount for the HP Period

= [HP principal × Flat rate of interest × HP period of years]

Step 3: Find HP Amount = Step 1 + Step 2

Step 4: Find Annual Instalment Amount = (Step 3 ÷ No. of Instalments)

Step 5: Find Effective Rate of Interest (ERI)

Rate of Interest: → PV of Future Annual Instalments = PV of HP principal amount payable

Step 6: Find Annual Interest Amount = Total Principal Outstanding at the beginning × ERI

Sum-of-years Digits Method: Under this method, the annual amount of interest is determined as follows:

Annual amount of interest = [Number of years of remaining HP period including the current year ÷ Total
of all digits representing the period of HP] × Total amount of interest for HP period.

Where,

Total amount of interest for HP period = Total amount payable × Flat rate of

interest.

Straight-Line Method: Under this method, the annual amount of interest is determined as an equated
annual financial charge as follows:

Annual amount of interest = Total amount of interest for HP period ÷ No. of HP periods