Chapter 30: Leasing, Hire Purchase, and Project Finance

Chapter 30
LEASING, HIRE PURCHASE, AND
PROJECT FINANCE

© 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

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

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.

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


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

DUBIOUS REASONS FOR LEASING
• Hundred percent financing
• Circumvention of certain controls
• Favourable Financial Ratios
• Favourable ratios


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

LEGAL ASPECTS OF LEASING
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.

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

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.


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.

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.

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.

CRITERIA FOR EVALUATING A
LEASE PROPOSAL
• Net present value
• Internal rate of return
• Equivalent loan amount


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.

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.

CHOICE BETWEEN LEASING
AND HIRE-PURCHASE
1. Estimate the post-tax cash flows associated with these
options.
2. 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.


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.


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.

MAIN PARTIES INVOLVED IN
PROJECT FINANCE ARRANGEMENTS

Project
sponsors

Lenders

Government
Project
company

Others
Customers

Contractors
Suppliers


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


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.

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 longterm non-cancellable arrangement. An operating lease is a shortterm 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.

• In finance literature, a leasing decision is commonly regarded as a
financing decision.
• The NPV of a finance lease is:
n
NPV = I - ∑
t =1

LRt (1 – T ) + DEPt x Tc
[1 + rD (1 – TC)]t

SVn
-

[1 + rD (1 – TC)]n

• 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.

Chapter 30: Leasing, Hire Purchase, and Project Finance

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Chapter 30: Leasing, Hire Purchase, and Project Finance