lease,hp,project finance
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LEARNING OBJECTIVES
Define lease and highlight its true advantages
Explain the methods for evaluating a lease
Discuss the concept of a leveraged lease
Highlight the difference between hire purchase
financing and lease financing
Focus on project financing as a special mechanism
for financing large projects
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Lease Defined
Lease is a contract under which a lessor, the owner of theassets, gives right to use the asset to a lessee, the user ofthe assets, for an agreed period of time for a considerationcalled the lease rentals.
In up-fronted leases, more rentals are charged in the initialyears and less in the later years of the contract. Theopposite happens in back ended leases.
Primary lease provides for the recovery of the cost of the
assets and profit through lease rentals during a period ofabout 4 or 5 years. It may be followed by a perpetual,secondary lease on nominal lease rentals.
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Types of Leases
1. Operating Lease
2. Financial Lease
3. Sale-and-lease-back
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Operating Lease
Short-term, cancelable lease agreements are calledoperating lease.
Tourist renting a car, lease contracts for computers,
office equipments and hotel rooms.The Lessor is generally responsible for maintenance
and insurance.
Risk of obsolescence remains with the lessor.
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Financial Lease
Long-term, non-cancelable lease contracts are known
as financial lease.
Examples are plant, machinery, land, building, ships
and aircrafts.
Amortise the cost of the asset over the terms of the
leaseCapital or Full pay-out leases.
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Sale and Lease Back
Sometimes, a user may sell an (existing) asset owned by him
to the lessor (leasing company) and lease it back from him.
Such sale and lease back arrangements may provide
substantial tax benefits.
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Cash Flow Consequences of aFinancial Lease
Avoidance of the purchase price
Loss of depreciation tax shield
Aftertax payments of lease rentals
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Advantages of Leasing
1. Convenience and Flexibility
2. Shifting of Risk of Obsolescence
3. Maintenance and Specialized Services
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Evaluating a Lease
Equivalent Loan Method
Net Advantage of a Lease Method
IRR Approach
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Equivalent Loan Method
EL is that amount of loanwhich commits a firm toexactly the same streamof fixed obligations asdoes the lease liability.
Method1. Find out incremental cash
flows from leasing.
2. Determine the amount ofequivalent loan such cash
flow can service.3. Compare the equivalent
loan so found with leasefinance.
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N t P t V l d N t
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Net Present Value and NetAdvantage of Leasing
The direct cash flow consequences are:
1. The purchase price of the asset is avoided.
2. The depreciation tax shield Is lost.
3. The after tax lease rentals are paid.
The net present value of these cash flows at
after tax cost of debt should be calculated. If it
is positive, lease is beneficial.
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Investment and Net Advantage of
Leasing
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L B fit t L d
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Lease Benefits to Lessor andLessee
A lease can benefit both when their tax ratediffers.
Leasing pays if the lessees marginal tax rate isless than that of the lessor. In fact in a lease, thelessee sells his depreciation tax shield to thelessor.
In the absence of taxes it is hard to believe thatleasing would be advantageous if the capital
markets are reasonably well functioning.Gain of both is loss to the government in form of
taxes.
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Leasing Benefits Comefrom
Both, lessor and lessee, gain at governments expense
because of the difference in their tax rates.
The government gains from the tax on lease rentals
while it loses on depreciation and interest tax shields.
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(NAL) includingOperating Costs and Salvage
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Internal Rate of ReturnApproach
IRR of a lease is that rate which makes NALequal to zero.
1. Ao = Purchase Price.
2. L = Lease Rentals.3. DEP = Depreciation
4. T = Tax Rate
5. OC = Operating Cost
6. SV= Salvage Value
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1 1
nn
ot n
tt
t
T L OC TDEP SVA
r r
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LEVERAGED LEASE17
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Hire PurchaseConditions
The owner of the asset (the Hirer or the manufacturer) gives thepossession of the asset to the Hirer with an understanding thatthe Hirer will pay agreed instalments over a specified period oftime.
The ownership of the asset will transfer to the hirer on thepayment of all instalments.
The Hirer will have the option of terminating the agreement anytime before the transfer of ownership of assets. ( Cancellable
Lease)
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Hire purchase financing
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Difference between Leasing andHire Purchase Financing
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Hire purchase Leasing
Hire purchaser can claimdepreciation
Lessee cant claim depn
Only interest included inannual hire purchasepayments tax deductible and
not the principle portion
Entire lease rentals are taxdeductible
Hire purchaser can claimsalvage value once allpayments are done
Lessee cant claim salvage
value , even if he has paid alllease rentals.
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Instalment Sale
Instalment Sale is a credit sale and the legal
ownership of the asset passes immediately to the
buyer as soon as the agreement is made between
the buyer and the seller.Except for the timing of the transfer of
ownership, instalment sale and hire purchase are
similar in nature.
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Evaluation of Hire PurchaseFinancing
The hiree charges interest at a flat rate, and he
requires the hirer to pay equal instalments at each
period.
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Project Financing
Scheme of financing a particular economic unit inwhich a lender is satisfied in looking at the cashflows and the earnings of that economic unit as a
source of funds, from which a loan can be repaidand to the assets of the economic unit as a collateralfor the loan.
It is different from the traditional form of financing,
i.e., the corporate financing or the balance sheetfinancing.
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Characteristics
1. Separate project entity
2. Leveraged financing
3. Cash flows separated
4. Collateral
5. Sponsors guarantees
6. Risk sharing
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Project financing allowssponsors to:
Finance projects larger than what the companys
credit and financial capability would permit,
Insulate the companys balance sheet from the
impact of the project,
Use high degree of leverage to benefit the equity
owners.
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Financing Arrangements for
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Financing Arrangements forInfrastructure Projects
1. The Build Own Operate Transfer (BOOT)
Structure.
2. The Build Own Operate (BOO) Structure.
3. The Build Lease Transfer (BLT) Structure.
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BOOT/BOO Structure of a Power Plant
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The Built-Lease-Transfer (BLT) Structure
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Project Financing Risk and theiAllocation
Risks1. Project Completion Risk
2. Market Risk
3. Foreign Currency Risk4. Inputs Supply Risk
Risk Mitigation
1. By Government
1. Country Risk2. Sector Policy Risk
3. Commercial Risk
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Financial Structure of
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Financial Structure ofInfrastructure Projects
Debt
Bonds
Equity
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and Financial Structure inInfrastructure Project FinancingReturn on equity
Risk measurement
Impact of guarantees
Financial structure
Taxes
Financial distress
Government restrictions
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