FINANCIAL SERVICES ASSIGNMENT

TOPIC: LEASE FINANCING

CONTRIBUTION BY TEAM MEMBERS

Page | 1
 SUMMARY OF LEASE FINANCING FROM FINANCIAL SERVICES BY
M.Y.KHAN

LEASING: basic definition

Leasing is a contract where a party being the owner (lessor) of an asset (leased asset)
provides the asset for use by the lessee at a consideration (rentals), either fixed or dependent
on any variables, for a certain period (lease period), either fixed or flexible, with an
understanding that at the end of such period, the asset, subject to the embedded options of the
lease, will be either returned to the lessor or disposed of as per the lessor's instructions.

ELEMENTS IN LEASE STRUCTURE

1. The transaction:

The transaction of lease of lease is generically an asset-renting transaction. What

distinguishes a lease from a loan is that in the latter, what is lent out is money; in a lease,
what is lent out is the asset.

2. Parties to a lease:

There are two parties to a lease: the owner and the user, called the lessor and the lessee. The
lessor is the person who owns the asset and gives it on lease. The lessee takes the asset on
lease and uses it for the period of the lease. Anyone can be a lessor, and any one can be a
lessee, subject to usual conditions as to competence to contract, or holding of properties.
Technically, in order to be a lessor, one does not have to own the asset: one has to have the
right to use the asset. Thus, a lessee can be a lessor for a sub-lessee, unless the parent lessor
has restricted the right to sub-lease.

3. The leased asset:

The subject of a lease is the asset, article or property to be leased. The asset may be anything
- an automobile, or aircraft, or machine, or consumer durable, or land, or building, or a
factory. Only tangible assets can be leased - one cannot contemplate the leasing of the
intangible assets, since one of the essential elements of a lease is handing over of possession,
along with the right to use. Hence, intangible assets are assigned, whereas tangible assets may
be leased.

4. Lease rentals:

The lease rentals represent the consideration for the lease transaction. This is what the Lessee
pays to the Lessor.

If it is a financial lease transaction, the rentals will simply be the recovery of the lessor's
principal, and a certain rate of return on outstanding principal. In other words, the rentals can
be seen as bundled principal repayment and interest.

Page | 2
 If it is an operating lease transaction, the rentals might include several elements depending
upon the costs and risks borne by the Lessor, such as:

Interest on the lessor's investment. If the lessor is bearing any repairs, insurance,
maintenance or operation costs, them charges for such cost. Depreciation in the asset.
Servicing charges or packaging charges for providing a package of the above service.

5. Lease period:

The term of lease, or lease period, is the period for which the agreement of lease shall be in
operation. As an essential element in a lease is redelivery of the asset by the lessee at the end
of the lease period, it is necessary to have a certain period of lease. During this certain period,
the lessee may be given a right of cancellation, and beyond this period, the lessee may be
given a right of renewal, but essentially, a lease should not amount to a sale: that is, the asset
being given permanently to the lessee.

TYPES OF LEASING

1. FINANCE LEASE

A lease is defined as finance lease if it transfers a substantial part of the risks and rewards
associated with ownership from the lessor to the lessee. According to the International
Accounting Standards Committee (IASC), there is a transfer of a substantial part of the
ownership-related risks and rewards if:

I. the lease transfers ownership of the asset to the lessee by the end of the lease term;
(or)
II. The lessee has the option to purchase the asset at a price which is expected to be
sufficiently lower than the fair market value at the date the option becomes
exercisable and, at the inception of the lease, it is reasonably certain that the option
will be exercised; (or)
III. The lease term is for a major part of the useful life of the asset. The title may or may
not eventually be transferred; (or)

Page | 3
IV. The present value of the minimum lease payments is greater than or substantially
equal to the fair market value of the asset at the inception of the lease. The title may or
may not eventually be transferred.

Features of financial leases:

Financial leases put the lessee in the position of a virtual owner. The lessor takes no asset-
based risks or asset-based rewards. He only takes financial risks and financial rewards, and
that is why the name financial leases.

The lease is non-cancellable, meaning the lessee cannot return the asset and not pay the
whole of the lessor's investment. In this sense, they are full-pay out, meaning the full
repayment of the lessor's investment is assured.

In financial leases, the lessor's payback period, viz., primary lease period is followed by an
extended period to allow exhaustion of asset value by the lessee, called secondary lease
period. As the renewal is at a token rental, this option is called bargain renewal option.
Alternatively, if the regulations permit, the lessee may be given a purchase option at a
nominal price, called bargain buyout or purchase option.

2. OPERATING LEASE

The IAS Committee defines an Operating Lease as "any lease other than a finance lease". An
Operating Lease has the following characteristics:

a. The lease term is significantly less than the economic life of the equipment.

b. The lessee enjoys the right to terminate the lease at short notice without any significant
penalty.

c. The lessor usually provides the operating know-how, suppliers, the related services and
undertakes the responsibility of insuring and maintaining the equipment in which case an
operating lease is called a 'wet lease'. An operating lease where the lessee bears the costs of
insuring and maintaining the leased equipment is called a 'dry lease'.

From the features of an operating lease, it is evident that this form of a lease does not shift the
equipment-related business and technological risks from the lessor to the lessee. The lessor
structuring an operating lease transaction has to depend upon multiple leases or on the
realization of a substantial resale value (on expiry of the first lease) to recover the investment
cost plus a reasonable rate of return.

3. SALE AND LEASEBACK

In a sale and leaseback transaction, the owner of equipment sells it to a leasing company
which in turn leases it back to the erstwhile owner (the lessee). The 'leaseback' arrangement
in this transaction can be in the form of a 'finance lease' or an 'operating lease'.

Page | 4
A classic example of this type of transaction is the sale and leaseback of safe deposit vaults
resorted to by commercial banks is Under this arrangement the bank sells the safe sells the
safe deposit vaults in its custody to a leasing company at a market price which is substantially
higher than the book value.

4. DIRECT LEASE

A direct lease can be defined as any lease transaction which is not a "sale and leaseback"
transaction. In other words, in a direct lease, the lessee and the owner are two different
entities. A direct lease can be of two types: Bipartite Lease and Tripartite Lease.

Bipartite Lease

In a bipartite lease, there are two parties to the transaction - the equipment supplier cum-
lessor and the lessee. The bipartite lease is typically structured as an operating lease with in-
built facilities like up gradation of the equipment (upgrade lease) or additions to the original
equipment configuration. The lessor undertakes to maintain the equipment and even replaces
the equipment that is in need of major repair with similar equipment in working condition
(swap lease).

Tripartite Lease

A tripartite lease on the other hand is a transaction involving three different parties -the
equipment supplier, the lessor, and the lessee. Most of the equipment lease transactions fall
under this category. An innovative variant of the tripartite lease is the sales-aid lease where
the equipment supplier catalyses the lease transaction. In other words, he arranges for lease
finance for a prospective customer who is short on liquidity.

5. LEVERAGED LEASE

In a leveraged lease transaction, the leasing company (called equity investor) invests in the
equipment by borrowing a large chunk of the investment with full recourse to the lessee and
without any recourse to it.

DOMESTIC LEASE & INTERNATIONAL LEASE

A lease transaction is classified as a domestic lease if all parties to the transaction to the
equipment supplier, the lessor and the lessee are domiciled in the same country. On the other
hand, if the parties are domiciled in different countries, the transaction is classified as an
International Lease Transaction.

LEGAL ASPECTS OF LEASING

As there is no separate statue for equipment leasing in India, the provisions relating to
bailment in the Indian Contract Act govern equipment leasing agreements as well section 148
of the Indian Contract Act defines bailment as:

Page | 5
The delivery of goods by one person to another, for some purpose, upon a contract that they
shall, when the purpose is accomplished, be returned or otherwise disposed of according to
the directions of the person delivering them. The person delivering the goods is called the
bailor and the person to whom they are delivered is called the bailee.

Since an equipment lease transaction is regarded as a contract of bailment, the obligations of

the lessor and the lessee are similar to those of the bailor and the bailee (other than those
expressly specified in the least contract) as defined by the provisions of sections 150 and 168
of the Indian Contract Act. Essentially these provisions have the following implications for
the lessor and the lessee.

1. The lessor has the duty to deliver the asset to the lessee, to legally authorise the lessee to
use the asset, and to leave the asset in peaceful possession of the lessee during the currency of
the agreement.

2. The lessor has the obligation to pay the lease rentals as specified in the lease agreement, to
protect the lessors title, to take reasonable care of the asset, and to return the leased asset on
the expiry of the lease period.

ACCOUNTING TREATMENT OF LEASE

An appropriate method of accounting is necessary for income recognition for lessor and asset
disclosure for the lease. Recognising the need for a proper accounting system for lease
transactions, IAS-17 was issued in 1982.

According to IAS-17, in case of operating lease, the lease has to allocate the aggregate lease
rental over the lease term on straight line basis. Financial lease should be shown in the
balance sheet of lessee as an asset to properly account for economic resources and as a
liability to reflect the level of its obligations. It stipulated that:

The asset and liability should be recorded at the inception of the lease at an amount
equal to the fair market value of the asset or the present value of the minimum lease
payment whichever is lower;
The lease rentals should be apportioned into interest and capital components using the
effective rate of interest/actuarial method;
The interest/finance charge should be expensed;
The leased asset should be depreciated in line with the depreciation policy of the firm
in respect of owned asset. It must be fully depreciated over the lease term or the
useful life whichever is shorter.

According to AS-19, the lessee should recognise the finance lease as an asset and a liability at
an amount equal to the lower of the fair value of the leased asset or the present value of the
minimum lease payments using the interest implicit in the lease/incremental borrowing rate
of the lessee as the discount factor. The lease payments should be apportioned between
finance charge and the reduction in the outstanding liability. The finance charge should be
allocated to periods during the lease term so as to produce a constant periodic rate of interest
on the remaining balance of the liability for each period. The depreciation policy should be

Page | 6
consistent with that of the owned asset. The asset should be fully depreciated over the lease
term or useful life whichever is shorter.

TAX ASPECTS OF LEASING

Leasing, as a financial device has income tax implications for, and offers tax benefits both to,
the lessor and lessee. The main attraction of leasing device to the lessor is the deduction from
his taxable income. The lease rental income of the lessor is included under the head Profits
and Gains of Business and Profession for the purpose of assessing the income tax liability.
While computing the income from leasing, depreciation on the leased asset is allowed as a
deduction to determine the taxable income. Depreciation claim by the lessor, thus, involves
tax shield on the leased asset.

Income tax consideration for the lessees are the claims for lease rentals and the operating cost
of the leased assets being treated as deductible expenses such as repairs and maintenance,
insurance and finance charge are treated as normal business expenditure.

LEASING CHAPTER REVIEW FROM FINANCIAL SERVICES BY TUMMULURI

SIDDAIAH

OUTLINE OF THE CHAPTER

The leasing industry in India has played a significant role. It is a source of financial strength
to many industries, especially SME. In spite of upheavals, leasing industry in India has
recorded a growth of 30% and is the third largest leasing industry in Asia after Japan and
Korea.

A Lease is an agreement in which one party (the owner or lessor) grants to another party (the
lessee) the right to use the asset in return for payment of certain amount, known as lease
rentals.

Lease is broadly classified into financial and operating lease. A financial lease is a long term
lease and period of the lease generally coincides with the economic life of the asset. An
operating lease might contain a cancellation clause according to which lessee has the right to
cancel the lease before its expiration without any penalty. Sale and lease back and Cross
border leasing are some other type of leasing options available.

LEASE EVOLUTION MODELS

Bothe the lessor and lessee evaluate a lease from their own perspective. The user has the
option to either buy or lease the asset. Before taking such a decision, the user must determine
whether leasing the asset involves lesser cost than buying it. Similarly, the supplier has the
options of leasing the asset or not to lease the asset based on return on capital required and
actually received by leasing.

Page | 7
Depending on the cash flows associated with the asset and the rate of required return, lessee
decides whether to go for asset or not. Thus, determining the financial viability is must before
taking a decision. Thus, it involves capital budgeting process. By applying DCF technique
firm can decide whether to go with the asset or not. Once this decision is made, next decision
of financing is taken.

An asset can be acquired by borrowed funds or through leasing. If the asset is acquired
through leasing, the lease is comparable to a loan as the firm is required to make a series of
payments. Leasing is thus, a substitute of debt financing due to its common capital structure
as that of debt financing.

A lease decision can be taken by applying an appropriate model. Popular models are:

I. WEINGARTNERS MODEL
II. BOWER-HERRINGER-WILLIAMSON MODEL
III. THE EQUIVALENT LOAN MODEL
IV. BOWERS MODEL

ADVANTAGE OF LEASING

It can be used as a substitute for debt financing.

It offers much more flexibility, as both the parties can come to an agreement which
can mutually benefit both.

ACCOUNTING PRACTICES FOR LEASING TRANSACTION

IAS 19 specifies the manner in which lease transactions should be accounted for in the books
of the lessee as well as lessor. According to the IAS 19, the definition of leasing includes
agreement for hire of the asset, and contains a provision giving the hirer the option to acquire
the title of the asset on fulfilment of agreed condition.

TAX IMPLICATIONS OF LEASING

According to the IT Act, the hirer is entitled to a tax shield on depreciation calculated with
reference to cash purchase price of the asset and on the consideration of the hire. From the
hires angle, the consideration received from hirer is liable to tax. Hire purchase agreements
are also subjected to tax.

Rest of the concepts covered were similar to the topics covered in financial services book by
M.Y.Khan as covered in above pages.

Page | 8
SUMMARY OF LEASE FINANCING FROM FINANCIAL MARKETS AND
SERVICES BY RAKESH SHAHANI

Leasing is a contractual agreement between two parties, the lessor who is the owner of the
asset and the lessee who is the user of the asset. The lessor gives the right to use the asset in
return for periodic payments which may be either monthly, quarterly, semi-annually or
annually. The payments are tailor-made to suit the needs of the lessee. When the lease period
ends, the leased asset reverts back to the lessor who is the owner of the asset. However, the
lessor may give option to the lessee after the end of the lease period to buy the asset for a
certain sum.

We generally talk of two types of lease agreements one is operating lease which is short
term cancellable lease agreement. Also, called the service lease the lease period under such an
arrangement does not fully amortize the cost of the asset i.e. the lessor is not able to recover
his investment in the asset by having a single operating lease agreement. Therefore, when the
lease with one lessee ends, the lessor undertakes lease agreement with another party. These
kind of lease agreements are common with computers, air conditioners, car rentals etc. The
maintenance cost, obsolescence, depreciation etc. of the leased asset is borne by the lessor
and he usually recovers it from the lessee in the form of add on to lease. Then for costly
assets the lessor may only partly finance the asset to be taken as lease while remaining of the
finance can come from a financial institution. The financial institution or lender gives a loan
which is secured by an asset. The lease rentals received are first used to repay the debt of the
lender and the surplus if any goes to the lessor. Such lease agreements are called leveraged
lease agreements.

WHY TO TAKE ASSET ON LEASE WHEN ONE CAN PURCHASE IT?

A lease agreement carries with it the hidden advantages that even a company which has
sufficient liquid resources and can easily purchase the asset, resorts to lease. The advantages
are:

1. Avoidance of immediate cash outflow: The natural advantage is that by taking an

asset on lease and not purchasing it, money is not flowing out of business
immediately and money being a precious resource can be put to other use.
2. The Lease rentals are tax deductible and hence give tax shields.
3. Avoiding the risk of obsolescence: In case of high risk industries where technological
development is very fast, leasing is preferable as the risk of obsolescence can be
easily passed on to the lessor.
4. Natural advantages over borrowing: As we know that the lessee has the option to take
a loan to buy the asset rather than to get the asset on lease. However, leasing is
sometimes more convenient as it has less restrictive conditions as compared to

Page | 9
 borrowing. It is less time consuming and the agreement contains no hidden clauses
like convertibility clause as in case of borrowing.

What prevents the business from taking lease on the asset?

The disadvantages with leasing are the Loss of Depreciation Tax shield and the Loss of
Interest Tax shield. The depreciation tax shield just like the lease rentals is an expense and
helps in saving taxes. In other words, the logic applied to tax shield on lease rentals can be
extended to depreciation too. Since depreciation was to be claimed by the lessor under the old
provision and not the lessee, it becomes a disadvantage for the lessee i.e. he loses the tax
shield on depreciation. Also, interest tax shield is a loss too, because had the purchaser taken
a loan to purchase the asset, he would have paid instalments on the loan, in which the lessee
could have saved tax on interest expense. Moreover, a bought asset would have scrap value at
the end of its life which is not there in the case of an asset taken on lease. The passing of new
provision that the lessee shall get the benefit of depreciation has removed some of the
disadvantages associated with leasing for the lessee. Since the new provision has changed the
equation, the lessor usually tries to compensate the loss in form of increase in lease rentals.

Choice of discount rate: As we know to evaluate whether leasing is preferable to buying an

asset we calculate the present value of the cash flows however; the question is what should be
the rate at which cash flow should be discounted to get their present values? One opinion is to
discount cash flow according to risk characteristics. Lease rentals are recurring in nature and
are bound to occur but various tax shields will occur only when there is profit. So, tax shields
being more uncertain than lease rentals should be discounted at a higher discount rate. But
this is not usually done as it is argued that the risk characteristics of tax shield are almost
similar to that of rentals of the tax shields can be carried forward to future years if these
cannot be availed of during any year and hence there should be only one discount rate which
shall be applicable to both lease rentals and tax shields. If there has to be one discount rate
whether the rate should be pre-tax or post tax. Now leasing is similar to debt obligation and in
a debt obligation the net cost of borrowing is always after tax interest rate. One important
implication of discounting cash flow post tax is that post tax takes care of loss of interest tax
shield placed on debt.

Page | 10
Formula for Accept/Reject criteria: The formula is to accept the leasing proposal if NPV or
Net Advantage of Leasing is Positive. Now NPV(L) is given by the formula:

AS PER NEW NORMS:

Page | 11
SUMMARY OF LEASE FINANCING FROM FINANCIAL MANAGEMENT BY
LOUISE GAPENSKI

Leasing is simple but unique, innovative source of medium term / long term of finance. It is a
method of acquiring the use of an asset without purchasing the asset. Leasing provides cent
percent finance to the business which requires new plant and machinery, other office
equipments , miscellaneous industrial, construction and commercial equipments. Hence it is
an alternative to borrowing funds for the purchase of fixed assets. This method of acquiring
fixed assets gained ground in western countries by the middle of this century. In India, it got
momentum only in the eighties. The growth in the volume of leasing activity in the recent
past shows that the business community in India has widely accepted this mode of financing.
It is estimated that there are nearly 1400 leasing companies (including private limited
companies) in India at present and many are in the offing. Banks both in the public as well as
in the private sector have managed to enter this field by starting subsidiaries. Of late, almost
all manufacturing groups have formed captive leasing units. Quite recently Reserve Bank of
India has issued orders allowing commercial Banks to indulge into the leasing field directly.
Leasing refers to a contract between the lessor who owns the equipment and the lessee (user),
for the lease of specifically approved items of equipment, on payment of a periodical amount
(lease rental) for a definite period of lease. The lease rental paid by the lessee to the lessor
incorporates the components of interest charges and the actual cost of an asset.

Page | 12
LEASING TRANSACTION :

A lessee chooses an asset and locates the lessor who will acquire it for him. The period
of lease may spread over the entire economic life of the asset. The ownership in legal terms
will always be with the lessor. The lessor may or may not be the manufacturer of the
equipment. If he is the manufacturer (which is not the case usually) he capitalises the cost
of the equipment in h i s books, funding it as a capital asset, and then gives it out on
lease to the lessee. If he is not a manufacturer, he will purchase the equipment from the
manufacturer paying the cost (including duties and taxes). He becomes the owner and
will capitalise it in his books and then leases it out. Basically there are two major forms
of leases - Financial lease and operational lease.

Finance Lease is also known as capital lease or full pay-out lease is generally a long term
lease. In this type, the lessee selects the equipments, settles the price and terms of sale and
arranges with a lessor to buy it. He takes the asset into lease by entering into irrevocable,
non-cancellable contractual agreement with the lessor for a fixed time period. The lessee uses
the equipment, exclusively, maintains it, insures it and avails after sales service and the
backing of warranty. In other words, all the risks and rewards incident to ownership is availed
by the lessee, while the lessor retains the legal ownership.

In financial lease there can be various options the lessor and lessee may exercise during or at
the end of the lease term.

a. Lease with purchase option - The lessee will have the option to buy the equipment.
Acquisition may be at a pre-determined price or at a price fixed at the time of transfer.
b. Lease with lessee enjoying Residual benefits The lessee will have the rate to share
a portion of the terminal sale proceeds or review the lease agreement at a bargain
rental.
c. Sale and Lease Back - This is an arrangement by which an entity that owns a given
asset may sell it to a lessor and then lease it back. This enables the lessee to
immediately defreeze the money that it has locked up in the said asset, and makes it
available for utilizing in a more profitable ventures.
d. Leverage Lease Leveraged lease involves the inclusion of a third party. The third
party may be a financier for a particular asset to be leased or owner of the asset. The
lessor manages to get loan from the third party at a rate lower than the return from
leasing.

Page | 13
 e. Consortium Leasing - Under this arrangement, two or more lessors may jointly
acquire the asset and lease it out to the lessee. In the case of assets which require huge
funds, a -single lessor may not be capable of acquiring it or may not be willing to
shoulder the entire risk associated with it. In such cases two lessors jointly own the
asset and share the rentals.

OPERATING LEASE - This type of lease is also known as maintenance lease or service
lease. Under this, the lessor has to maintain and service the leased equipment and the cost of
maintenance is built into the lease payments. Because of the inclusion of service charges in
the lease rentals, operating lease rentals will be comparatively higher than other leases.
Operating lease may contain a cancellation clause which can be exercised either by the lessor
or lessee. The lessor can take away the equipment on circumstances like misbehaviour of the
lessee, non payment of the rental in time, misuse of the equipment for a use not shown in the
contract etc.

Among the different forms of leases, Indian leasing companies offer financial leases. Most
leases have a primary period of five years, followed by a secondary period. Lease can be
front loaded (more rentals charged in the earlier years) or back loaded (less rentals charged in
the initial years). There is also equated lease which is equated in terms of payment over the
period of lease.

Lease Versus Hire Purchase and Instalment Selling:

A leasing transaction can be distinguished from a Hire purchase transaction or that of

payment by instalments. In the case of payment by instalments, the user actually becomes the
owner on payment of first instalment. The balance is to be paid in periodic instalments. But in
a hire purchase transaction, some down payment is made, the balance being payable over a
specified period. Even though ownership is passed on only on the payment of last instalment,
he is deemed to be the owner at the very beginning.

In the case of leasing, the leased asset is not shown in the balance sheet of the lessee. But
the lease rentals are debited to Profit and Loss Account. Further, as the lessee is not the
owner, he cannot claim depreciation on the leased assets. As against this, the hire purchase
capitalises the asset brought under him purchase contract although ownership is not acquired
by him until the end of the contract. He can claim depreciation as he is the deemed owner.
Thus, advocates of leasing vociferously claim that this is a covenient mode of financing

Page | 14
assets due to the off balance sheet reporting and entitlement of 100 percent tax deduction
inspite of losing depreciation benefits.

Advantages of Lease Financing

Lease financing has following advantages

a. To Lessor:

Assured Regular Income: Lessor gets lease rental by leasing an asset during the period of
lease which is an assured and regular income.

Preservation of Ownership: In case of finance lease, the lessor transfers all the risk and
rewards incidental to ownership to the lessee without the transfer of ownership of asset hence
the ownership lies with the lessor.

Benefit of Tax: As ownership lies with the lessor, tax benefit is enjoyed by the lessor by way
of depreciation in respect of leased asset.

High Profitability: The business of leasing is highly profitable since the rate of return based
on lease rental, is much higher than the interest payable on financing the asset.

High Potentiality of Growth: The demand for leasing is steadily increasing because it is one
of the cost efficient forms of financing. Economic growth can be maintained even during the
period of depression. Thus, the growth potentiality of leasing is much higher as compared to
other forms of business.

Recovery of Investment: In case of finance lease, the lessor can recover the total investment
through lease rentals.

To Lessee:

Use of Capital Goods: A business will not have to spend a lot of money for acquiring an
asset but it can use an asset by paying small monthly or yearly rentals.

Tax Benefits: A company is able to enjoy the tax advantage on lease payments as lease
payments can be deducted as a business expense.

Cheaper: Leasing is a source of financing which is cheaper than almost all other sources of
financing.

Page | 15
 Technical Assistance: Lessee gets some sort of technical support from the lessor in respect
of leased asset.

Inflation Friendly: Leasing is inflation friendly, the lessee has to pay fixed amount of rentals
each year even if the cost of the asset goes up.

Ownership: After the expiry of primary period, lessor offers the lessee to purchase the assets
by paying a very small sum of money.

SALES TAX PROVISION PERTAINING TO LEASING:

a. Levy of Sales Tax:

Sales Tax is leviable when goods are sold. Thus there must be " Goods and there must be a
sale. "Goods include all types of movable property. Sale " means a transfer of property in
goods from one person to another for a consideration. But Sales Tax is leviable only on a
person who is a dealer. A casual transaction by a non-dealer is not subject to Sales Tax. Thus,
if an individual salary earner sells off his personal car, there is no Sales Tax attracted. To
summarize, Sales Tax is leviable on sale of goods by a dealer.

b. Sales Tax on financial leases:

In a Finance Lease, NBFCs are the owner of the Goods and the lessee only has the right to
use the goods on payment of lease rentals. It is a contract of hiring or bailment. Hence there
is no sale as defined.

However, there is a transfer of the right to use the goods from us to the lessee. And this has
become taxable as a deemed sale. The Sales Tax, also called "Lease Tax ", is leviable on the
Transfer of Right to Use the goods from us to the lessee. And the tax is charged as each rental
for use of the lease asset becomes due and payable.

INCOME TAX PROVISIONS RELATING TO LEASING:

The principal income-tax provisions relating to leasing are as follows:

1. The lessee can claim lease rentals as tax-deductible expenses.

2. The lease rentals received by the lessor are taxable under the head of Profits and Gains of
Business or Profession.
The Difference between Financial Leasing and Loans

Page | 16
From the lessees perspective, there is only one substantive difference between a loan and a
lease: with a loan, the asset belongs to the borrower, whereas with a lease, the asset belongs
to the lessor.

The many similarities between a loan and a financial lease include:

The lessee and borrower have the choice over the acquisition of the asset. The
borrower and lessee (providing the terms of the lease are met) would be able to retain
the asset once payments are complete.
Over the period of both a loan and a lease, interest and capital (equipment cost) are
repaid.
Should there be default on either a loan or a lease, as long as the loan is secured, both
the lender and lessor have legal rights to reclaim/repossess assets.
The risks and costs of ownership, including maintenance and obsolescence, remain
with the borrower and lessee. Also, under both a loan or a financial lease, if the asset
appreciates, neither the lender nor the lessor benefits.
The agreements are non-cancelable until either the lessor or the lender has recovered
its outlay.
The borrower or lessee can either settle the agreement (in the case of the lease) or
repay the loan early.

Lease or Buy Decision

Lease or buy decision involves applying capital budgeting principles to determine if leasing
as asset is a better option than buying it.
Leasing in a contractual arrangement in which a company (the lessee) obtains an asset from
another company (the lessor) against periodic payments of lease rentals. It may typically also
involve an option to transfer the ownership of the asset to the lessee at the end of the lease.
Buying the asset involves purchase of the asset with companys own funds or arranging a
loan to finance the purchase.
In finding out whether leasing is better than buying, we need to find out the periodic cash
flows under both the options and discount them using the after-tax cost of debt to see where
does the present value of the cost of leasing stands as compared to the present value of the
cost of buying. The alternative with lower present value of cash outflows is selected.

After-tax cash flows of lease

Determining periodic cash flows in case of leasing is easy. Most leases involve periodic fixed
payments and an optional one-time terminal payment. They may also involve payment of
insurance, etc. associated with the asset which also need to be accounted for. These payments
have associated tax shield, i.e. they are allowed as deduction from the companys taxable
income which results in a decrease in net tax liability of the company.

Page | 17
Periodic after-tax cash flows of lease = (maintenance costs + lease rentals) * (1 tax rate)
Terminal after-tax cash flows = periodic after-tax cash flows + amount paid at purchase the
asset

After-tax cash flows of purchase

The most significant component of cash outflows in case of purchase of asset is the payment
for cost of the asset. If the company uses its own funds, the total cost is assumed to be paid at
the time 0, however, if the company obtains a loan to finance the purchase, the loan
repayment and associated tax shield on interest shall appear in all the periods of the lease
analysis.
Other cash flows include the tax shield on depreciation, any potential savings, maintenances
costs, insurance, etc. associated with the purchase and use of the asset.
Once we know the after-tax cash flows under both the alternatives, we just need to find
present values for each option using the companys after-tax cost of debt and choosing the
option that has lower present value of cash outflows.

EXAMPLE ON LEASE FINANCING

B-Tel, Inc. is a telecommunication services provider looking to expand to a new territory Z; it

is analyzing whether it should install its own telecom towers or lease them out from a
prominent tower-sharing company T-share, Inc.
Leasing out 100 towers would involve payment of $5,000,000 per year for 5 years.
Erecting 100 news towers would cost $18,000,000 including the cost of equipment and
installation, etc. The company has to obtain a long-term secured loan of $18 million at 5%
per annum.
Owning a tower has some associated maintenance costs such as security, power and fueling,
which amounts to $10,000 per annum per tower.
The companys tax rate is 40% while its long-term weighted average cost of debt is 6%. The
tax laws allow straight-line depreciation for 5 years.
Determine whether the company should erect its own towers or lease them out.

Solution

Annual cash out flows of leasing (Year 1 to Year 5) = $5,000,000 * (1 40%) = $3,000,000
Annual cash flows of purchasing have three components: the loan amount to be repaid in
each period, the maintenance costs to be borne each year, the tax shields associated with
maintenance costs, depreciation expense and interest expense. The following table
summarizes the calculation of cash flows under this alternative.
Period 1 2 3 4 5
Loan A 4,157,546 4,157,546 4,157,546 4,157,54 4,157,546
repayment 6
Maintenance B 1,000,000 1,000,000 1,000,000 1,000,00 1,000,000
costs 0
Depreciation D 3,600,000 3,600,000 3,600,000 3,600,00 3,600,000
0

Page | 18
Interest expense I 900,000 737,123 566,101 386,529 197,978
Total tax T= 5,500,000 5,337,123 5,166,101 4,986,52 4,797,978
deductions B+D+I 9
Tax shield @ t= 2,200,000 2,134,849 2,066,441 1,994,61 1,919,191
40% 0.4T 2
Net cash flows N= 2,957,546 3,022,697 3,091,106 3,162,93 3,238,355
A+Bt 5
Annual loan repayment is based on present value calculation; it is the amount paid at the end
of each year for 5 years that would write off the loan completely. It is calculated using the
following MS Excel function: PMT (5%,5,-18000000).

Interest expense are calculated in the following debt amortization table:

Opening Total Principal Closing

Period Interest
Principal Repayment Repayment Principal
0 18,000,000 - - - 18,000,000
1 18,000,000 4,157,546 900,000 3,257,546 14,742,454
2 14,742,454 4,157,546 737,123 3,420,424 11,322,030
3 11,322,030 4,157,546 566,101 3,591,445 7,730,585
4 7,730,585 4,157,546 386,529 3,771,017 3,959,568
5 3,959,568 4,157,546 197,978 3,959,568 -
It is necessary to prepare amortization table because tax laws do not allow deduction of total
loan amount, instead only interest expense is allowed as deduction.
Depreciation is calculated on straight-line basis using the 5-year useful life (i.e.
$18,000,000/5 = $3,600,000).
Tax shield is subtracted from loan repayments and maintenance costs while calculating the
net cash outflows because tax shield represents a cash inflow which arises due to tax
deductibility of the expenses.
Now, we have to calculate the present value of cash outflows under both the options using the
after-tax cost of debt which is 3.6% (6% * (1-40%))
Present value of leasing at 3.6% = $13,545,157
Present value of purchasing at 3.6% = $13,950,176
Since leasing has a lower present value of cash outflows, it should be the preferred option.

NEWS AND LATEST UPDATES ON LEASING SECTOR IN INDIA

1. RBI clarifies on financial leases covered in NBFC

The banking regulator had been receiving requests for clarifications as to whether operating
leases would not be permissible

Page | 19
In a notification, the Reserve Bank of India (RBI) has clarified that the activity leasing and
finance, which is one among the 18 NBFC (non-banking financial companies) activities
wherein foreign investment up to 100% is permitted under the automatic route, covers only
financial leases and not operating leases, so far as the NBFC sector is concerned.

The banking regulator had been receiving requests for clarifications as to whether operating
leases would not be permissible.

On 8thMay, the RBI amended the extant policy for foreign investment to allow foreign
investors to invest without FIPB (Foreign Investment Promotion Board) approval in the
NBFC sector.

2. The air-leasing sector may soon face harder times

Cheaper oil has helped many parts of the aviation industry, but it may hurt the leasing sector.

When oil prices were high, airlines were desperate to replace gas-guzzling planes with new,
fuel-efficient ones. Given the daunting commercial outlook, many preferred to lease their
new jets, leaving the leasing firms to stump up the capital required to buy planes. Leasing
firms are now responsible for about 40% of the big plane makers sales.

As a result, leasing has become voguish. Cheerleaders claim that average annual returns have
topped 10% in recent yearsan astronomical figure in a world of low yields. Investors have
been keen to pile in, allowing the leasing firms to raise money for new jets directly by issuing
bonds, rather than via bank loans. Boeing forecasts that 53% of the aircraft it sells to lessors
this year will be financed this way, up from about 33% four years ago. Big leasing firms have
been raising other forms of capital, too: BOC Aviation, Chinas largest, floated in Hong Kong
on June 1st.

But the oil price began falling in 2014. Despite a recent rally, it is still less than half what it
was then. Cheap fuel makes older, less efficient planes profitable to run again. That has
stoked fears that the world will soon have more planes than it knows what to do with. The
number of new orders seems to be slowing (see chart). Richard Anderson, until last month the
boss of Delta, Americas second-biggest airline, has muttered about an aircraft bubble. The
airline bought a used Boeing 777 for $7.7m in Decembera 97% discount to the listed price
for a new one.

The leasing firms themselves insist they are not short of customers. Although demand for
cargo planes has stalled, that for passenger aircraft is still rising. International passenger
volumes grew by 4.6% year-on-year in April, with aircraft-utilisation rates reaching near-
record levels, according to IATA, an industry group. But the share price of Americas biggest
listed lessors fell at the start of the year, because of fears that profits will come under
pressure.

3. Uber-wants-to-disrupt-the-auto-leasing-industry

Page | 20
Think about all the money that goes into leases and loans from captive financing units at
Toyota, Honda and Ford, luring consumers into shiny new vehicles.

Automobile financing amounts to $116 billion a year just in the United States, according to
IBIS World, all for the sake of car ownership or something resembling it.

Uber's mission is very different than that of a car company. It wants more Ubers on the road
by any means necessary, and the newer the car, the better. After all, it's setting out to create
the anti-taxi experience.

The company created Exchange Leasing last year as a wholly-owned Uber subsidiary. For a
$250 deposit, an Uber driver can lease a new midsize or economy car, be it a Chevrolet
Malibu, Honda Accord or Toyota Prius.

Uber is changing car ownership for drivers, with flexible options that allow people to get
access to a car when they want to earn extra income. EXchange is one of several products
Uber now offers. Another program lets drivers whose cars are in the shop get weekly rentals
from Enterprise at a discounted rate and with unlimited miles.

And for those who want to own, Uber has deals with all the major manufacturers for fleet
discounts typically of $1,000 to $5,000. In May, Toyota invested in Uber as part of a strategic
deal that will include new leasing options through Toyota Financial Services.

Like the ride-sharing business, auto financing is a slog and requires country-specific
solutions. In Singapore, Uber started a subsidiary rental company called Lion City Rentals,
while in countries such as China, India and France, it's mostly working with third parties.
Financing cars by the thousands is hugely expensive. Xchange secured a $1 billion credit
facility led by Goldman Sachs, according to a person familiar with the matter.

4. Improving Chads Business Climate through Lease Financing

Chad is making a big push to improve its business climate and create a friendlier environment
for entrepreneurs who run small and medium enterprises and industries (SMEs and SMIs).
At the end of 2014, Chadian Members of Parliament passed a draft law on the establishment
and regulation of lease financing for SMEs and SMIs that will have a significant impact on
how business in the country will be done going forward.

The introduction of lease financing was a reform provided for in the June 2014 cooperation
agreement between the Government of Chad and the International Finance Corporation
(IFC), in the context of the Africa Leasing Facility program, and it is now starting to bear
fruit.

Ferdinand Ngobounan, the head of the IFC leasing program in Chad, explained that the
passage of this law allows Chadian entrepreneurs to overcome a number of obstacles
associated with the financing of their businesses, given that leasing is an alternative financial
product that allows SMEs and SMIs to finance their equipment without systematic recourse
to traditional collateral.

Page | 21
5. Piramal Fund Management aims Rs 10,000 crore lease rental discount deals by FY18

Taking its diversification strategy further, Piramal

Groups financial services arm Piramal Fund
Management has expanded its portfolio to offer flexi
lease rental discounting (LRD). Through these
transactions, the fund will discount future cash flows
of completed and leased commercial assets including
office blocks and retail malls, said a top company
official.

The fund has already identified an initial pipeline of

deals and is in advanced talks with two developers--one each in Mumbai and Bengaluru--to
conclude LRD deals totaling Rs 1,500 crore for their leased office complexes. The fund
intends to scale its book size up to Rs 10,000 crore by 2017-18.

This is part of our diversification and innovation strategy. We believe that we are in the
business of forging strong relationships on the back of our ability to act as a provider of
perpetual capital and have been working on perfecting this structure for many months.
Through this innovative form of flexi LRD, we can be with the developer partners for 18
years including first six years of construction finance and then LRD with tenure of up to 12
years, Khushru Jijina, MD, Piramal Fund Management said.

COMPANY ANALYSIS- SHRIRAM TRANSPORT FINANCE CO. LTD.

Company Profile Established in 1979, Shriram Transport Finance Co Ltd. is the largest asset
financing NBFC with Rs. 36997 cr. worth of assets under management. The company is a
leader in organized financing of pre-owned trucks with strategic presence in 5-12 year old
trucks and a market share of 20-25 percent. It has a pan-India presence with a network of 68
SBUs and 488 branches, and has built a strong customer base of over 7.5 lacks. Over the past
30 years, it has developed strong competencies in the areas of loan origination, valuation of
pre-owned trucks and collection.

The company is involved in following activities:

Financing of pre-owned and new commercial and passenger vehicles, tractors, 3

wheelers, multi-utility vehicles, etc.
Finance for working capital, engine replacement, bill discounting, credit cards and
tyre-loans as holistic financing support.
Financing of pre-owned and new Construction equipment through Shriram Equipment
Finance Company Limited, a 100% subsidiary
Owns, operates and manages Auto mall, Indias first pre-owned commercial vehicle
physical auction platform through Shriram Auto mall India Limited, a 100%
subsidiary Sale of refurbished commercial vehicles through Shriram New Look

Page | 22
 Operates Electronic Kiosks having intranet, to facilitate buying and selling of pre-
owned commercial and passenger vehicles within own branches.

Business Analysis

The company is one of the largest assets financing NBFC with approximately 20-25% market
share in pre-owned and approximately 7- 8% market share in new truck financing. The
company is strategically present in high yield - pre-owned CV financing with expertise in
loan origination, valuation and collection.

The company has expanded product portfolio to include financing of tractors, small
commercial vehicles, 3-wheelers, passenger commercial vehicles and construction
equipment. The company has a strategic mix of retail deposits and institutional funding with
retail liabilities constituting 22.4 percent of the total external borrowings and loans from
banks and institutions accounting for 77.6 percent.

The company has a Pan-India presence through a network with 69 Strategic Business Units
(SBUs), 494 branch offices and has partnership with over 500 Private Financiers. The
company continued to strengthen its network also through private financiers. The company
has large customer base in excess of 0.9 million.

STFCs subsidiary Shriram Automall India Limited owns, operates and manages Automall to
provide facilitation services to potential buyers and sellers of pre-owned commercial vehicle.
It presently operates 57 Automalls across India.

STFC is listed on the BSE Ltd (stock code: 511218) and the National Stock Exchange of
India Ltd (stock code: SRTRANSFIN). Its market capitalization as on March 31, 2016 stood
at Rs. 21,625 cr.

FINANCIAL PERFORMANCE

On standalone basis,

Assets under management Rs.72, 760.60 crore

Securitisation done for the year 2015-16 Rs.8,
991.75 crore
Total income for the year 2015-16 Rs.10, 245.26 crore
The profit after tax stands at Rs.1, 178.20 crore
Net interest income for the year 2015-16 Rs.5, 072.73 crore
The earning per share stands at Rs.51.93

Page | 23
Page | 24