Better Evaluation of a Lease

Better Evaluation of a Lease V Raghunathan In the October-December 1986 issue, Vikalpa published an article on leasing by I M Pandey who outlined an ...
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Better Evaluation of a Lease V Raghunathan

In the October-December 1986 issue, Vikalpa published an article on leasing by I M Pandey who outlined an approach to lease evaluation, treating leasing as functionally equivalent to debt and using the borrowing rate for discounting cashflows. V Raghunathan argues in this article that treating leasing as functionally equivalent to debt is flawed. He outlines an investment approach to evaluating a lease using the weighted average cost of capital for discounting instead of the borrowing rate. In addition to outlining his approach, Raghunathan comments on the Indian leasing scene and on the myths and realities about leasing. V Raghunathan is Associate Professor in the Finance and Accounting Area at the Indian Institute of Management, Ahmedabad.

Literature on leasing is beginning to multiply in India as fast as the number of leasing companies themselves. Unfortunately, this growth in literature seems to be adding to the general confusion rather than abating it. The article by I M Pandey titled "Myths and Realities about Leasing" (Vikalpa, October-December 1986), though lucidly written, fails to clear the confusion. The approach used and the conclusions drawn by him are flawed. In this article, I critique the approach used by Pandey and outline a better approach to lease evaluation that envisages a useful economic role for leasing, and comment on the Indian leasing scene. The myths and realities about leasing narrated by Pandey are misleading. In Box 1, I have commented on these myths under the heading "More on the Myths and Realities about Leasing."

Approach to Lease Evaluation Pandey uses the same discount rate for both lessor and lessee, namely the going rate of interest for long term funds in the market. This approach provides no economic role to leasing other than as a market for trading in tax shields, resulting in a joint minimization by lessor and lessee of their tax. In this approach, leasing has no role to play when both lessee and lessor profit by the transaction. If both profit and absorb their respective tax shields in the period in which they accrue, both will have the same discount rate, namely the after-tax interest rate (say r(l—T), where r is the interest rate and T is the corporate tax rate). Also cashflows for the two' are identical except that inflow for one is outflow for the other and vice

versa. Thus, the net advantage of leasing (NAL) for one would imply a net disadvantage of leasing for the other. This implies that leasing can never be acceptable to both when both have profitable operations (except when both are indifferent, NAL being zero). In this approach, therefore, leasing has no internal economic justification since the lessor is always assumed to be loss making, which is the raison d'etre for a lease deal to be acceptable to both. Such a position is untenable simply because no activity which presupposes losses is worth undertaking in the first place. What should then be the correct approach to lease evaluation? To answer this question, it is 38

necessary to take a closer look at the differences in the perspectives of the lessee and lessor to lease evaluation.

Lessee's Perspective Let us assume that a profitable firm is considering the acquisition of a capital asset. Assuming that the objective of the firm is to maximize wealth for its shareholders, its decision making process may be viewed as follows: If the present value of the net operating cashflows (accuring from the deployment of the asset) when discounted at the overall cost of capital of the firm (in order to ensure maximization of wealth to its shareholders) Vikalpa

exceeds the investment, the asset would be acquired or else it would be rejected. 1 Such a decision process is said to be based on the net present value (NPV) criterion. The asset may be acquired by the firm either by outright purchase or by leasing. The two options may be viewed as two mutually exclusive projects of which only one can be accepted. The problem then simply reduces to ranking the two alternatives in terms of their NPVs and selecting the alternative with a higher NPV. Purc:hase Option

n

+L: i=1

where A Xj

n

2:

i=l

DiT (1 +. K)i

In case the asset is acquired through a lease. there might typically be a small downpayment as advance rental. followed by a stream of further rental payments on the one hand and receipt of the stream of operating cash inflows on the other. The lease rentals are taxed. Further the operating cash inflows in this case would be identical to those under the buy option, assuming that the maintenance and other related costs of the asset are borne by the finn under both options. Thus, the asset may be leased if: n-t

When the asset is purchased by the firm outright, there is typically a large cash outflow by way of the acquisition cost of the asset, followed by a stream of operating cash inflows which are taxed. Further the firm receives tax shield on depreciation (and investment allowance if applicable). Finally, the salvage value ofthe asset accrues to the firm with an appropriate terminal depreciation or a balancing charge as the case may be. Thus, the asset may be purchased if

NPVp =-A+

Lease Option

+

Xi(t- 11 (1 + K)i

s (1 + K)D

>O

(1)

= =

acquisition cost of the asset net operating earning at the end of period i T == income tax rate (per cent) Di = depreciation amount at the end of period i s ·= post-tax salvage value, adjusted for terminal depreciation or balancing charge K = weighted average cost of capital of the finn. which is discussed in greater detail later. (Note : The investment allowance term may be introduced if necessary) , II is assumed that the deployment of the asset does not change the risk class ofthe finn.

Vol. 12, No.2. April-June 1987

NPVJ =-L-L: i=l

n Xj(t-11

+L:

.

i=t (t+K)l

L

n

LT

------+~----~

(1 +K)i

i=1

s +-->0 (t+K)n

(1 +K)i

{2)

where L = equalized lease rentals 0, if the asset reverts to the lessor, and S- b. if by paying a nominal amount b s = to the lessor, the firm can somehow acquire possession of the asset which is worth S. 2 In equation (2), the advance payment of lease rentals has been stressed, so that the advance rental may be visualized as the initial investment. Further. the Land LT terms are separated to highlight the far.t that in general the two cashflows payment of the rental and tax shield on it-occur in different time periods. Cost of Capital: The Disc:ount Rate

The weighted average cost of capital (K) of the firm is given by K

= Ke

D

E

D+E + r(l-11 D+E

where Ke

= estimated the firm

{3)

cost of equity capital for

2

While in the current Indian practice the asset must revert to the lessor, this auumption of s=S-b is valid when, through a third party deal. a firm is able to acquire the asset worth S for a price b. thereby 'circumventibg' the law. The interpretation is purely economic and not meant to suggest the circumvention which is already a well-known practice in the Indian leasing industry.

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r = cost of borrowings, i.e. the interest rate D:E = the target debt to equity ratio for the firm, based on market value, since the firm's objective function, viz. the shareholders' wealth, is determined only at the market place. It should be noted that in the above approach the tax shield on interest is captured in the discount rate rather than in cashflows. Alternatively, the tax shield on interest may be captured in cashflows rather than in the discount rate. The latter approach is especially suited to situations where the tax shield on interest may not be absorbed in the year in which it accrues.

Lessee's Decision Now, the decision would be to lease the asset if NPV1 > NPVp > 0, and buy the asset if NPVp > NPV1 > 0. Alternatively, if NPV1 — NPVD be referred to as the net advantage of lease (NAL), we have the decision rule: Lease if NAL > 0 and NPV1 > 0 and Purchase if NAL < 0 and NPVp > 0 Thus the asset should be leased if both the net advantage of leasing and the net present value of the lease are positive. The asset should be purchased if the net advantage of leasing the asset is negative and the net present value of the purchase option is positive. The net advantage of leasing (NAL) is given by NAL = equation (1) — equation (2)

By equating NAL to zero, one may solve the equation for L, which would yield the breakeven rental or the maximum rental that the firm would be prepared to pay the lessor, so as to be indifferent between the buy and lease options.

Lessor's Perspective At this point it becomes obvious that the lessor's 40

approach to the lease evaluation would also be identical to equation (4) except that the cashflows would have the opposite signs and, more importantly, would have a different discount rate, i.e. the lessor's weighted average cost of capital. Thus, the lessor would decide to lease if NAL > 0 and not lease if NAL < 0. It should be noted that NPVp and NPV1 are irrelevant to the lessor, since his earnings do not come from the deployment of the asset. Therefore, the only decision relevant to him is whether to lease or not to lease the asset. Here it is assumed that the lessor would actually invest in the asset only if he can lease it. The differences in the perspective to leasing of the lessee and the lessor can be summarized as below:

An important difference in the perspective between the lessee and the lessor arises because the same terms of a lease have different values for them. This is because of differences in their costs of capital. While the average debt to equity ratio in India of a lessee is 2:1, that of a lessor is typically upwards of 6:1.

Approximations and Errors In employing equation (4) for lease evaluation, it should be recognized that rental cashflows are monthly or quarterly, whereas tax shields are normally realized only on a quarterly or annual basis. Thus to arrive at NAL or breakeven lease rental, annual cashflows are discounted at the annual rate, whereas monthly or quarterly cashflows are discounted at equivalent (time adjusted) ^onthly or quarterly rate. In a casual treatment, however, the monthly discount rate is arrived at by merely dividing the annual discount rate by 12. This would be obviously erroneous, since this treatment disregards the time value of money. It is surprising that, in a carefully illustrated article, Pandey overlooks the importance of accuracy in Vikalpa

this regard. Such casual treatment of discount rate can impart a considerable degree of error in arriving at the breakeven lease rental. This has been illustrated in Box 2 under the heading "On the Hazards of Approximation." Box 2 On the Hazards of Approximation

When annual cashflows are discounted by an annual rate, say r, the time-adjusted equivalent monthly rate rm for discounting the monthly cashflows is given by rm = (l+r)1/12 - 1 Similarly, the equivalent quarterly discount rate rq is given by r q = (1 + r) 1 / 4 - 1

and so on. Instead of using these formulas, the casual approximation generally used is to divide the annual rate by 12 to get the monthly rate and to divide it by 4 to get the quarterly rate. This may be too gross an approximation. To appreciate the extent of difference, breakeven monthly lease rentals have been calculated for the example employed by Pandey in his paper, using time-adjusted rate and the casual approximations. Let Acquisition cost of asset: Rs 1000 Period of lease: 8 years Depreciation rate: 30 per cent Salvage value: 0 Annual discount rate: 6.75 per cent Unadjusted monthly discount rate: 6.75/12 = 0.5625 per cent Time adjusted equivalent monthly discount rate: (1.0675)1/12 —1= 0.5458 per cent Using the unadjusted discount rate of 0.5625 per cent Pandey arrives at a monthly breakeven rental of Rs 16.43. However, when the time adjusted monthly discount rate is used, with due regard to the fact that lease rentals are monthly while tax shields are not, the monthly breakeven rental works out to Rs 15.20. There is a difference of Rs 1.23 per Rs 1000 of asset. It should be clear that, in dealing with time value, casual approximations introduce a very high degree of error. What is more, this error increases as the discount rate increases. When amounts involved are large, as in leasing, such approximations can be hazardous. Similarly, one must guard against the tempfation to divide the annual breakeven rental by 12 to arrive at the monthly breakeven rental.

Vol. 12, No. 2, April-June 1987

Breakeven Lease Rentals Using the above framework, we may now work out the breakeven lease rentals for a typical lessor and lessee in the Indian context. We shall make the following assumptions: Lessor's debt to equity ratio 6:1 Lessee's debt to equity ratio 2:1 Cost of equity for lessee and lessor 30 per cent Cost of debt for lessor (being largely public deposits) 13.5 per cent Cost of debt for lessee 18 per cent Tax rate 50 per cent Using equation (3), these parameters imply a weighted average cost of capital of about 10 per cent for the lessor and 16 per cent for the lessee. For the above two discount rates, Table 1 gives the monthly breakeven lease rentals for Rs 1000 worth of an asset for 5 and 8 year leases for different depreciation rates and salvage values. From Table 1, we see that, when the salvage value of the asset is assumed to be zero and depreciation rate is say 30 per cent, the minimum monthly lease rent which the lessor (with a discount rate of 10 per cent) would need to receive is Rs 24.31 in order to break even on the deal. For the same parameters, the maximum monthly lease rent which the lessee (with a discount rate of 16 per cent) can afford to pay in order to be indifferent between his lease and buy options would be Rs 28.73. In such a case any leasing transaction between the lessor and the lessee at a monthly rent ranging between Rs 24.31 and Rs 28.73 per Rs 1000 of the asset would be advantageous to both. In other words, within this rental band NAL for both the lessor and the lessee will be positive.

Determinants of Leasing Economics It is clear that when both lessee and lessor have exactly opposing cashflows, are in the same marginal tax rates, are able to absorb their tax shields, and have identical discount rates, no lease deal would be struck on economic criteria since NAL 41

Tablet: Monthly Breakeven Lease Rent on Rs.tooO Worth 'Of Asset (in Rupees) Discount Lease

Salvage Value

Rate(%} Period

.Re.o

Hs.Z50

Rs.500

Hs.lOOO

Depreciation Rate{%) 22.5 15 30

Depreciation Rate(%} 15 22.5 30

Depreciation Rote (% J 15 22.5 30

Depreciation Rote (% J 15 22.5 30

10

5

25.62

24.91

24.31

19.04

18.19

17.55

22.54 17.40

21.83

8

16

5

30.62 24:17

29.60

28.73

28.03

27.01

8

22.95

22.01

22.92

21.70

16.55

would never be positive for both. Thus the assumption of the same discount rate for both lessor and lessee must be incorrect. A lower cost of capital for the lessor as compared to the lessee gives rise to a situation where NAL is positive for both. In this situation, the benefit from leasing to both primarily comes from the lower cost of capital of the lessor as compared to that ofthe lessee, and not . at the cost of the government. In India this condition is obtained simply because the debt to equity ratio of a lessor is normally much higher than that of an average lessee. This is because the government allows a leasing company to raise ten times its equity as deposits from public. Assuming, however, that both the lessee and the lessor are profitable and have more or less the same discount rates, tax advantages ofleasing may be forthcoming to both provided the lessee is in a higher marginal tax rate than the lessor and not the other way

21.23 15.90

19.45 15.75

18.75 14.90

18.14 14.26

13.29 12.46

12.58 11.61

11.98

26.14 20.76

25.44 21.67

24.42

23.55 19.51

20.26 19.17

19.24

18.37 17.01

20.45

10.96

17.95

round. Table 2 illustrates this point. It is assumed that both have the same discount rate, say 10 per cent. However, the lessor's marginal tax rate is assumed at 50 per cent. and the lessee's at 60 percent.3 For different values of depreciation rate and salvage value, Table 2 provides the monthly breakeven rentals for a five year lease on Rs 1 OOf) worth of asset. From Table 2, it is evident that so long as the lessor is in a lower marginal tax rate than the lessee for any combination of all other parameters held constant for both parties, the minimum lease rent required by the lessor turns out to be lower than the maximum rent affordable by the lessee, so that an economic deal profitable to both the lessor and the lessee can be struck. Under this situation, while the government allows tax shield on rentals &om the lessor on a higher tax rate, it collects taxes on rentals from the lessor at a lower rate. In this situation the government is a net

Table 2: Effect of Marginal Tax Rate on Moathly Breakeven Lease Reat on Rs.tOOO Worth of Asset

(in Rupees)

Para-

meters

Marginal

Salvage Value

Applied Tax .Rate(%) To (years)

Re.O De~iotion

15

Lessor Lessee

50 60

25.62 27.83

22.5 24.91 26.'79

Rs.500

Rs.250

Hate (%)

Depreciation Hate {% J

Rs.lOOO

Depreciation Rate(%)

Depreciation Rote(%)

30

15

22.5

30

15

22.5

30

15

24.31 25.91

22.54 24.82

21.83 23.78

21.23 22.90

19.45 21.80

18.75

18.14 19.89

13.29 15.78

20.77

22.5 12.58 14.75

30 11.98 13.87

a condition may obtain in·India. when the lessor Is a widely held public company while the lessee is not.

3 Such

42

Vikalpa

loser to the extent of the difference. However, the government presently allows tax shield on depreciation to the lessor at a lower tax rate as compared to the rate it allows to the lessee if he purchased and used the asset. On this count the government benefits to the extent of the difference. Thus, whether on the whole a lease deal is struck at the cost of the government would depend on the relative values of the tax impacts concerning lease rentals and depreciation to the government. However, even when both the lessee and the lessor have the same discount rate and enjoy the same marginal tax rate (largely true for Indian companies, except for the difference between the marginal tax rates for the closely versus widely held companies), tax advantages of leasing may still be forthcoming to both if the lessor had unabsorbed accumulated losses so that the tax impacts were shifted to future with resultant smaller NAL. Only under this situation the government may really lose out in the form of lost taxes, even as the deal benefits both. Even when this situation prevails, the correct approach for lease evaluation is to adjust the cashflows for deferred tax shields and not the discount rate as done by Pandey. Further, from Tables 1 and 2 we can see that the spread between the breakeven rentals of the lessor and the lessee are also affected by changes in depreciation rate, salvage value, and tax rate, even if the discount rates of the lessor and the lessee are unchanged. Thus, the determinants of leasing economics may be summed briefly below: • the differential costs of capital of the lessor and the lessee • marginal tax rates of the lessor and lessee • unabsorbed taxes of the lessor and the lessee • governmental policies on taxation and depre ciation • market factors affecting the asset's salvage value for the lessor and the lessee.

Indian Leasing Scene Lease Undefined Though considerable strides have been made by the leasing industry in India in recent years, the Vol. 12, No. 2, April-June 1987

uninitiated would be shocked to know that "leasing" as understood in the present day is as yet undefined in Indian law. In fact the "definition" for leasing can only be arrived at by negation of other legal definitions. For instance, in order to prove a transaction as a lease transaction for tax purposes, it may often be necessary for one to ensure that the transaction in question is not a "sale" or "hire purchase" or some other form of "transfer of property" so that, by default, the transaction is regarded a "lease." It is, however, to the credit of Indian enterprise that a fairly workable "definition" of a lease has tacitly come to be agreed upon by all concerned, thanks primarily to the First Leasing Company of India Ltd. I have outlined the position with regard to lease definition in Box 3 under the heading "Archaic Origins of Definition of Lease in India." Low Rentals: Short Term and Long Term Considerations

Notwithstanding the lack of leasing legalities, there are upward of 600 leasing companies in India today. Perhaps a good many of them are mere traders in unabsorbed losses. However, the sharp spurt in the number of leasing companies from less than 10 in 1982 to nearly 600 today is widely said to have depressed the lease rentals below what may be healthy for the leasing industry. To see the veracity and the extent of truth in this contention, let us revert to Table 1. For a depreciation rate of 30 per cent, the table indicates that the breakeven monthly rental for a lessor, with a discount rate of 10 per cent, is Rs 24.31. In other words, on any particular lease deal, the lessor must receive a minimum rental of Rs 24.31 per Rs 1000 of asset in the short run so as to recover his marginal costs. In the long run, however, the lessor must recover not only his marginal cost on a specific lease deal but also his fixed overhead costs from rentals. Assuming a 5 per cent share of overheads in lease rentals, over a period of time the lessor must receive a rental of Rs 24.30 X 1.05 = Rs 25.50 per month on a Rs 1000 asset for a fiveyear lease. Evidently, the current rentals in the market are much lower at about Rs 23.24 for comparable parameters, despite the fact that the breakeven rental for the lessee (with a discount 43

rate of 16 per cent) is much higher at Rs 28.73. In other words, even if the lessor were to charge a rental higher than Rs 25.50 it would still be affordable by the lessee, given our assumed parameters, so long as the rental was kept below Rs 28.71. This indicates that the current lease rentals in the industry are indeed low, although the market can sustain higher lease rentals. How many companies will survive if such low rentals continue is anybody's guess. At the same time, it is interesting to note that levying a sales tax of 5 per cent on lease rentals, as is being done by more and more states, reduces the spread available between the breakeven rental of the lessor and the lessee further. For instance, a 5 per cent sales tax would imply that the breakeven rental of the lessor would be up again by 5 per cent, thereby making it Rs 26.75 (Rs 25.50 X 1.05), which leaves a narrower spread of just about Re 1 for the lessor and the lessee to negotiate. Clearly, there is little further scope for burdening the leasing industry with any further taxation. Further, the Indian leasing companies must wake up to the fact that they are structurally very different from their counterparts in the West where most leasing companies are often merely extended arms of banks. The situation is quite different for the private leasing companies in India which are intermediaries between financiers and ultimate users of money. It is rather difficult for a private leasing company to have as low a cost of capital as that of a financial institution and hence it can scarcely afford to match such a low rental structure. Entry of banks into leasing makes the situation only worse for private leasing companies.

Discount Rate: Caution Against Using the Rate of Interest By now, it can be readily seen that lowering the discount rate lowers the monthly breakeven lease rent. It is, therefore, tempting to believe that, in addition to reasons of growing competition, perhaps use of the interest rate as the discount rate for leasing evaluation may also be responsible for the low level of rentals in the Indian market. Even if the leasing industry does not consciously use the interest rate for discounting for purposes of Vikalpa

lease evaluation, the same effect is indirectly obtained when the leasing companies try to match the rental structures of a financial institution like ICICI which obtains its funds at about 12 per cent a year and thus has an after-tax discount rate of 6 per cent. At 6 per cent discount rate, ICICI's short term monthly breakeven rental is a mere Rs 21.30 (not taking into account the tax shield on investment allowance). Thus when ICICI quotes a rental of Rs 23 on a five-year lease, the implicit rate of return is merely 8.5 per cent after tax or 17 per cent before tax, which is higher than its cost of capital. One must recognize that a perpetual underestimation of breakeven rentals by the lessor (when the lessee's approach is right) would lead to acceptance of potentially unprofitable leases by him. On the other hand, underestimating of breakeven rentals by the lessee (when the lessor's approach is right) may result in his buying the assets which in fact he should have leased. However, given the current scenario when probably both the lessor as well as the lessee may be underestimating their breakeven rentals, it should be clear from the above analysis that the net loser would be the lessor and not the lessee, since the latter's actual breakeven rental at Rs 28.71 is much higher.

Future for Indian Leasing Unfortunately the bulk of leasing companies that have sprung up lately have entered the fray with an eye on the third determinant of leasing economics, namely unabsorbed losses. Thus, such leasing companies have deviated from their true economic role as financiers and have become mere traders in unabsorbed losses as is evidenced by an increasing number of in-house leasing firms and sale and lease-back deals. Also, more often than not, manufacturers have been setting up leasing companies just to circumvent their

Vol. 12, No. 2, April-June 1987

debt to equity ratio norms which is pegged at 2:1. By setting up a leasing company, a manufacturer indirectly enjoys a debt to equity ratio limit up to 10 : 1. It is in fact this tendency of Indian industry to short circuit an otherwise economically relevant and necessary activity which is abhorable and not the activity of leasing per se. One should not be too surprised if before long we see some legislation curbing this tendency. Already the situation gives rise to a feeling of deja vu: we have seen it happening in the treatment of manufacturing expenses, in the context of capitalization of interest, and may be (with some reservations) in the context of "zero tax" companies. Already, the latest move by the government requiring all companies to pay taxes on 30 per cent of book profits is bound to be felt particularly hard by the leasing companies, which have wittingly or unwittingly been bookkeeping their way to huge profits and paying large dividends in recent years. The mismatch that often prevails between the asset's economic life and the lease period easily affords the opportunity for such shortsighted accounting policies. In addition, most leasing companies are indiscriminately employing relatively short period funds (public deposits) on long term leases of five to eight years. High dividend payout in initial years coupled with potential liquidity problems in later years of the leasing business is bound to set off the fuse which might well blow many a leasing company to oblivion before one full cycle of eight years of leasing is through. The leasing industry may yet survive, but probably with far fewer leasing companies than at present. The economic role of leasing must extend far beyond that of enabling trading in tax shields. Leasing is, and must be, viewed as a further division of labour: a specialized activity concentrating on bringing suppliers and users of money together, thereby more sharply differentiating and realigning risks and returns in the economy.

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