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5. Political risk
– Change in government fiscal policy viz depreciation or
Tax rates
– Add clause for revision of LR
5. Currency & cross border risk
– Fluctuation in exchange rate
– Hedging can be done
DEFAULT / CREDIT RISK
DETERMINANTS OF CREDITWORTHINESS
• Character
– Integrity, honesty commitment
– From informal reports
• Capacity
– DE ratio
– Interest coverage ratio
– Cash flow coverage ratio
– Whether lessee is using creative accounting techniques to manage
depreciation , valuation of inventories , accounting for leases ,
accounting for foreign currency translation ,disclosure of prior
period, contingent liabilities & extraordinary items to dress up
Financial statements
DETERMINANTS OF CREDITWORTHINESS
• Collateral
– Value maintained by the leased equipment
APPROACHES TO CREDIT RATING
• Explicit judgmental approach
– Define set of factors for credit rating & assign weights
• Net worth 40
• Current ratio 35
• Profitability 25
– Give scores on 0 -1 scale to lessee
• Net worth 0.6
• Current ratio 0.8
• Profitability 0.5
– Obtain overall scores
• Net worth 40 * 0.6 = 24
• Current ratio 35 * 0.8 = 28
• Profitability 25 * 0.5 = 12.5
64.5
APPROACHES TO CREDIT RATING
• Statistical approach
• Hence gross yield (pre tax) is compared with cost of funds (pre
tax)
• In practice, cut off rate is pre tax cost of funds plus a profit margin
PRACTICAL PROBLEM OF GROSS YIELD
• A company has developed the following table for default risk
classification on basis of gross yield
risk class required yield
A 19 %
B 21%
C 24%
D 25%
Proposal in hand
lease term 5 years
LR 25 ptpm in advance
1) Credit rating reveals that lessee can be placed in ‘B’, can this proposal
be accepted?
2) Assume if 3 months LR is taken in advance & out of which 2 months
would be adjusted against payment due for last two months of lease
term, will the answer be different?
SOLUTION part 1
• 25 * 12 * PVIFA p (i,5) = 1000
• 300 * i / d 12 * PVIFA (i,5) = 1000
• i / d 12 * PVIFA (i,5) = 3.333
• At i = 0.18, LHS of equation = 1.095 * 3.127 = 3.424
• At i = 0.20, LHS of equation = 1.105 * 2.991 = 3.305
• Interpolating in range (18,20) we get
• i = 0.18 + 0.02 * 3.333 – 3.424
3.305 – 3.424
• 0.1953 or 19.53 %
• Manager should not accept proposal as in risk class B required
rate of gross yield is 21 %
SOLUTION part 2
• (25 * 2) + [25 * 12 * PVIFA p ( i , 4.833) ] = 1000
• 4.833 years = 58 months
• PVIFA p ( i , 4.833) = 950 / 300 = 3.167
• At i= 0.20
1.105 * 2.928 = 3.235
• At i= 0.22
1.115 * 2..807 = 3.130
• Interpolating in range (20,22) we get
• i = 0.20 + 0.02 * 3.167 – 3.235
3.130 – 3.235
• i = 0.20 + 0.02 * 0.068
0.105
• 21.29 % , we can accept as gross yield is higher than required yield for
B class
ADD ON YEILD
• Calculate add on yield of previous question
• Initial investment = 1000
• Aggregate LR paid
during the period (25 * 60)= 1500
• Aggregate interest charge = 500
over the period
• Average annual interest charge = 100
( 500 / 5 )
• Add on yield = 10 %
( 100 / 1000 * 100)
• This measure of yield provides a distorted picture of true cost of lease to lessee ( 19.53 %
compared to 10 %)
GROSS YIELD BASED PRICING
• IFSL uses gross yield price approach at pre tax cost of funds plus 1.3
%.Incremental cost of debt & cost of equity is 15 & 21 %.Gearing ratio is
4 : 1Tax rate is 51.75%.For a lease term of 5 years company collects 1 %
management fees upfront & spend 0.5 % of investment as indirect cost
upfront & 5% as residual cost after 5 years
• Calculate marginal cost of capital
• Calculate annual LR collected annually in arrears
• Assuming step up pattern by 10 % P.A calculate LR annually in arrears
• Calculate LR monthly payable in advance
• Deferred payment where no LR for 12 months & then monthly in advance
SOLUTION part a & b
• a)
• Marginal cost of equity 21 % = 43.5 %
( 1- 0.5175)
• Marginal cost of capital [4/5 *0.15 + 1/5 *0.435]
• Required gross yield 20.70 % + 1.3 % = 22 %
• b)
• 10 + L * PVIFA (22,5) + 50 * PVIF(22,5) = 1000 + 5
• 10 + 2.864 L + (50 * 0.370) = 1005
• 2.864 L = 976.5
• L = 341
SOLUTION part b& c
• b)
• [ L * PVIF(22,1) + 1.1 L PVIF (22,2) + (1.1)2 L *PVIF(22,3) +
(1.1)3 L *PVIF(22,4) + (1.1)4 L *PVIF(22,5) + 10 + 50 * PVIF (22,5)] =
1000 + 5
• 3.368 L = 976.50
• L = 290 to be charged in first year
• c)
• 12L * PVIFA p ( 22,5) + 10 + 50 * PVIF(22,5) = 1000 + 5
• 38.320L + 10 + 18.5 = 1005
• L = 976.5 / 38.320
• L = 25.48 ptpm
SOLUTION part d
• d)
• 12L * PVIFA p ( 22,4) * PVIF(22,1) + 10 + 50 *
PVIF(22,5) = 1000 + 5
• 10 + 27.363 L + 18.5 = 1005
• 27.363 L = 976.5
• L = 35.69 ptpm
IRR OF A LEASE
• Some companies evaluate lease using criterion of IRR
• INFERENCE