LEASE EVALUATION:

LEASE:

A lease is a contract conferring a right on one person (called a tenant or lessee) to

possess property belonging to another person (called a landlord or lessor) to the

exclusion of the owner landlord. It is a rental agreement between landlord and tenant.[1]

The relationship between the tenant and the landlord is called a tenancy, and the right

to possession by the tenant is sometimes called a leasehold interest. A lease can be for

a fixed period of time (called the term of the lease) but may be terminated sooner. The

consideration of the lease is called rent or rental.

LEASE EVALUATION: THE LESSE’S ANGLE:

A Finance lease can be evaluated either as an investment alternative or as a financing

alternative depending upon the a priori information available about the financial

desirability of a capital investment. In the absence of any a priori information about the

financial desirability, ‘Leasing’, and ‘Buying’ are evaluated as two mutually exclusive

investment alternatives. Given prior knowledge of the financial desirability or need for a

capital investment, ‘Leasing ‘is evaluated as one of the financial alternatives.

FINANCIAL MODELS FOR EVALUATION OF THE LEASE:

There are a number of financial models for evaluating a lease and there is

no consensus till date on the most appropriate model. The following four

financial models represent the spectrum of views on this issue reasonably

well:

A Weingartner Model

B Equivalent Loan Model

C Bower- Her ringer- Williamson model

D Bower Model

Barring the first model, the other three models are evaluating the leasing as

a financial alternative.

- The application of the Weingartner Model to evaluate a lease as an

investment alternative involves the following steps:

A) Compute the NPVs of the lease and buy alternatives

B) Select the alternative with the higher positive NPV.

-The application of the Weingartner Model for evaluating a lease as a

financing alternative involves the following steps:

A) Compute the NET ADVANTAGES OF LEASING (NAL) defined as:

NAL = Initial investment – P.V (Lease Rentals) – Management Fee + P.V. (Tax

Shield on Lease rentals) + P.V. (Tax Shield on Management Fee) – P.V. (Tax

Shield on Depreciation) – P.V.(Net Salvage Value).

B Lease the equipment if NAL is positive. Buy the equipment if NAL is

negative.

The discount rate employed is the marginal cost of capital based on the mix

of the debt and equity in the target capital structure. The model assumes

that debt includes present and future lease obligations as well.

- The Equivalent Loan Model, The BHW model And the Bower Model view

‘Leasing’ as a financing alternative and is based on the premise that every

rupee of lease finance displaces an equal amount of long term debt. In other

words, these models assume that the debt component in the target capital

structure does not include present and future lease obligations. So, these

models consider the interest tax shield on the displaced debt as an explicit

cash flow in the computation of NAL. .The models differ from one another in

terms of the discount rates applied to the components of NAL viz., lease

payments, tax shields (shelters) and net salvage value. The following table

provides the different discount rates employed by these models:

Components of

NAL

Equivalent loan

Model

BHW model Bower model

A Lease

payments

Pre- Tax Cost of

debt

Pre-Tax Cost of

debt

Pre- tax cost of

debt

B Tax Shield Post tax cost of

debt

Marginal cost of

capital

To be specified

by the decision

maker

C Net Salvage

Value

-Do- - Do- Marginal cost of

capital

-

- We believe that the risk characterizes the lease payment on the one hand

and the realization of the tax shelters and the net salvage valve on the other

hand are different. Hence different discount rates have to be used to

discount the two set of tax flows. For reasons stated we also believe that

debt displacement effect of leasing must be explicitly recognized and now

NAL is:

NAL= Investment cost- P.V (lease payments discounted at Kd) + P.V (Tax

shield on lease payments discounted at K)- Management Fees +P.V ( Tax

shield on management fees discounted at K)- P.V ( Depreciation Tax shield

discounted at K) – P.V ( Residential value discounted at K)

Kd= Pre-Tax cost of Debt

K= Marginal cost of capital

Setting NAL to 0 and solving the unknown rental value provides the break

even rental from the lessee’s point of view- the maximum lease rental

acceptable to lessee.

LEASE EVALUATION: THE LESSOR’S ANGLE:

The Net Advantage of Leasing from Lessor’s point of view can be defined as

follows:

NAL= - Initial investment + P.V (Lease payments) – P.V ( Tax on lease

payments) + P.V (Management fee) –P.V ( Tax on management fee) + P.V

( Tax shield on Depreciation ) + P.V ( Net Salvage Value) – P.V ( Indirect cost)

= P.V ( Tax shield on initial direct cost).

- The bargaining area or the range within which the rentals can be negotiated

between the lessor and the lessee is determined by the break even rental of

the lessor and the lessee. The upper limit is determined by the break even

rental of the lessee and the lower limit is set by the break even rental of the

lessor. Clearly, no negotiable range exists if the break even rental of the

lessor exceeds that of the lessee.

- Lessor who use the gross yield approach to price the lease define the gross

yield as that rate of interest which equates the present value of the lease

rentals plus the present value of the residential value of the investment cost.

- The flat rate of interest applicable to a lease is called the add on yield. The

assumption underlying the computation of add on yield is that the

investment in the lease remains constant over the lease period, which is

untrue. The add on yield is always less than the (effective) gross yield

defined above.

- The Internal rate of return (IRR) on a lease is that rate of interest for which

NAL is equal to zero. The lease proposal is accepted if and only if IRR is

greater than the marginal cost of capital.

- The total risk of the lease portfolio can be divided in to following types of the

risk:

A Default Risk

B Residual Value Risk

C Interest rate risk

D Purchasing Power Risk

E Political risk

F Currency and the cross border risk.

- The relevant and the dominant risk characterizing a finance lease is the

default risk. The default risk is the function of the creditworthiness of the

lessee which is influenced by the character and capacity of the lessee and

the collateral value of the asset.

- The overall credit rating of the lessee based on the relevant factors can be

determined through the explicit judge mental approach and the statistical

approach. These approaches primarily help in discriminating between the

good and the bad lessee account and also help in developing a risk

classification table.

- The credit risk can be managed by altering one or more of the lease

structuring variables like leases rentals, lease term or pattern of the

payments. The Lessor can also seek protection against credit risk by insisting

on personal and bank guarantee.

- The relevant risk in the case of an operating lease is the product risk or the

risk inherent in realizing the expected salvage value. In the countries like

USA and UK, insurance companies offer the residual value of the insurance

policies to cover such risks.