1. Chapter 30 LEASING, HIRE PURCHASE, AND PROJECT FINANCE
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2.  Centre for Financial Management , Bangalore
OUTLINE
Types of Leases
Rationale for leasing
Mechanics of leasing
Operating Lease
Financial lease in the Context of Capital Budgeting
Leasing as a Financing Decision
Hire Purchase Arrangement
Choice between Leasing and Hire Purchase
Project Finance
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TYPES OF LEASES
A lease represents a contractual arrangement whereby
the lessor grants the lessee the right to use an asset in
return for periodical lease rental payments
Leases may be classified as follows:
Finance lease vs. operating lease
Sale and lease back vs direct lease
Single investor lease vs leveraged lease
Domestic vs international lease
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FINANCE LEASE
A finance lease, or capital lease, is essentially a form of borrowing. It salient features are:
An intermediate term to long-term non-cancellable
arrangement.
Fully amortised during the primary lease period.
Lessee is responsible for maintenance, insurance, and
taxes.
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OPERATING LEASE
An operating lease is a lease other than a finance lease. Its salient features are:
The lease term is significantly less than the economic life
of the equipment
The lessor usually provides the operating know-how and
insures and maintains the equipment
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6. PLAUSIBLE REASONS FOR LEASING
Convenience
Benefits of standardisation
Better utilisation of tax shields
Fewer restrictive covenants
Lower cost of obsolescence risk
Expeditious implementation
Matching of lease rentals to cash flow capabilities
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7. DUBIOUS REASONS FOR LEASING
Hundred percent financing
Circumvention of certain controls
Favourable Financial Ratios
Favourable ratios
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MECHANICS OF LEASING
Legal aspects of leasing
Typical contents of a lease agreement
Sales tax provisions relating to leasing
Procedural aspects of leasing
Income tax provisions relating to leasing
Accounting treatment of leases
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9. LEGAL ASPECTS OF LEASING  Centre for Financial Management , Bangalore
As there is no separate statute for equipment leasing in India, the provisions relating to bailment in the Indian Contract Act govern equipment leasing agreements as well.
In essence, it means the following:
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
The lessee has the obligation to pay the lease rentals as
specified in the lease agreement, to protect the lessor’s
title, to take reasonable care of the asset, and to return
the leased asset on the expiry of the lease period.
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10. INCOME TAX PROVISIONS RELATING TO LEASING
Depreciation can be claimed by the lessor and not the
lessee
Lease rentals received by the lessor are taxable under
the head of ‘Profits and Gains of Business or Profession’
The lease rentals paid by the lessee are tax-deductible
expenses for the lessee.
These provisions apply to operating as well as finance leases
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11. ACCOUNTING TREATMENT OF LEASING
Operating leases are capitalised in the books of the
lessor. Lease payments are treated as income of the
lessor and expense of the lessee.
Finance leases must be capitalised in the books of the
lessee.
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12. ACCOUNTING TREATMENT OF FINANCIAL LEASE
In a finance lease, the leased equipment is shown as an
asset on the balance sheet of the lessee. Its value is
equated to the present value of the committed lease
rentals. The leased asset is matched by a corresponding
liability called the ‘lease payable’.
Lease payments are split into two parts : finance charge
is treated as an expense on the profit and loss account
and the principal amount is deducted from the liability
‘lease payable’.
The leased asset is ‘depreciated’ in the books of the
lessee as per its depreciation policy.
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OPERATING LEASE
Conceptually, the decision rule for choosing between buying and leasing is fairly simple. Buy the asset if the post-tax EAC (equivalent annual cost) of ownership is less than the post-tax lease rental; lease the asset if the post-tax EAC of ownership and operation is more than the post-tax lease rental.
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14. LEASING AS A FINANCING DECISION
In finance literature, a leasing decision is commonly regarded as a financing decision. The decision to invest in the asset is taken for granted and the option of leasing is compared with the option of buying with borrowed funds. Leasing is compared with borrowing because both of them entail similar obligations.
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15. CRITERIA FOR EVALUATING A LEASE PROPOSAL
Net present value
Internal rate of return
Equivalent loan amount
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16. WHEN IS A FINANCIAL LEASE MUTUALLY BENEFICIAL
Other things being equal, the potential gains from leasing are more when:
The tax rate of the lessor is much higher than the tax
rate of the lessee.
The depreciation charges are significantly higher in the
initial years of the lease.
The lease is structured in such a way that the lease
payments are concentrated toward the end of the lease
period.
The interest rate is high.
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17. FEATURES OF A HIRE PURCHASE ARRANGEMENT
The hiree purchases the asset and gives it on hire to the
hirer.
The hirer pays regular hire purchase instalments over a
specified period of time. These cover interest as well as
principal repayment.
The hiree charges interest on a flat basis.
The total interest collected by the hiree is allocated over
various years using some method like the ‘sum of the
years digits’ method.
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18. CHOICE BETWEEN LEASING AND HIRE-PURCHASE
Estimate the post-tax cash flows associated with these options.
Calculate the present value of cash flows associated with the two options (using the post-tax cost of debt as the discount rate) and choose the option which has a lower present value.
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PROJECT FINANCE
Project finance involves raising funds for a capital investment project that can be economically separated from its sponsor. The suppliers of funds depend primarily on the cash flows of the project to service their loans and provide return on their equity investment in the project.
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20. FEATURES OF PROJECT FINANCE
The project is set up as a separate company which is
granted a concession by the government.
The sponsor company which promotes the project usually
takes a substantial stake in the equity of the project and
enjoys the over all responsibility for running the project.
The project company enters into comprehensive
contractual arrangements with various parties like
contractors, suppliers, and customers.
The project company employs a high debt-equity ratio,
with lenders having no recourse or limited recourse to the
sponsor company.
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21. MAIN PARTIES INVOLVED IN PROJECT FINANCE ARRANGEMENTS
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DISTINCTIVE FEATURE
The distinctive feature of project finance is a web of contractual arrangements, which may change over time, designed to distribute various risks inherent in the project to parties best qualified to appraise and control them. Hence project finance represents an efficient way of allocating and managing risks
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GVK POWER
GVK Industries sponsored GVK Power, the project company, to set up power project. GVK Power entered into the following contracts with various parties.
A turnkey execution contract with ABB, Switzerland
An operations and maintenance contract with CMS
Corporation
A power purchase agreement with APSEB
A loan agreement with IFC, ADB, and Indian financial
institutions.
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24.  Centre for Financial Management , Bangalore
SUMMING UP
A lease represents a contractual arrangement whereby the lessor
grants the lessee the right to use an asset in return for periodical
lease payments.
A finance lease, or capital lease, is an intermediate term to long-
term non-cancellable arrangement. An operating lease is a short-
term cancellable lease.
There are some plausible reasons for leasing and there are some
dubious reasons for leasing.
The lessor is entitled to claim depreciation for income tax
purposes. The lease rentals are taxable receipts in the hands of
lessors and tax-deductible expenses for the lessee.
For accounting purposes, operating leases are capitalised in the
books of the lessor whereas financial leases are capitalised in the
books of the lessee.
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25.  Centre for Financial Management , Bangalore
In finance literature, a leasing decision is commonly regarded as a
financing decision.
The NPV of a finance lease is:
Under a hire-purchase agreement, the hirer (the counterpart of
lessee) enjoys the benefits of ownership. The hirer pays periodic
hire purchase instalments to the hiree (the counterpart of the
lessor) which covers interest as well as principal repayment.
The distinctive feature of project finance is the manner in which
project risks are allocated to various parties involved in a project.
Through a comprehensive web of contracts, every major risk
inherent in the project is allocated to the party/parties that is
best able to assess and manage that risk.
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