CONCEPT OF LEASE CONTRACT

Lease Lease is a contractual agreement between two parties under which one party (owner
It is a contract of an asset) gives another party (user of an asset) the exclusive right to use the assets,
between two usually for a specific period of time in return for the payment of rent. Lease rent is
parties under which
paid either at the beginning or at the end of the year.
one party sold his
exclusive right to In other word, a lease may be defined as a contractual arrangement/ transaction in
use the specific
which a party owning an asset (lessor) provides the asset for use to another/transfer
assets in return for
the lease rent. the right to use the asset to the user (lessee), over a certain/for an agreed period of
time, for consideration in form of/in return for periodic payment, with or without a
further payment. At the end of the period of contract (lease period), the asset reverts
back to the lessor unless there is a provision for the renewal of the contract.
 Generally assets having high cost are leased.
 The assets in which technology changes rapidly are leased.
 The lease transfers ownership of the asset to the lessee by the end of the lease term.
 The lessee has the option to purchase the asset at a price that is expected to be
sufficiently lower than the fair value at the date the option becomes exercisable
such that, at the inception of the lease, it is reasonably certain that the option will
be exercised.
 The lease term is for the major part of the economic life of the asset even if title is
not transferred.
 at the inception of the lease, the present value of the minimum lease payments
amounts to greater than or at least substantially equal to the fair value of the leased
asset, and
 the leased asset is of a specialized nature such that only the lessee can use it
without major modifications being made.
The lease is terminated and various courses are possible, namely (i) the lease is
renewed on a perpetual basis or for a definite period, or (ii) the asset reverts to the
lessor, or (iii) the asset reverts to the lessor and the lessor sells it to a third party or (iv)
the lessor sells the asset to the lessee.

Party involved in Lease Contract

Basically there are two parties involved in lease contract but in some special
contractual agreement, there may be three parties involved.
a. Lessor: The owner of an assets or a person who sold his or her exclusive right to
use the specific assets to another party or lessee or lessor is the owner of the
assets that are being leased.
b. Lessee: User of an assets or A person who buy the exclusive right to use the
specific assets from the owner of the assets (lessor) or lessee is the receiver of the
services of the assets under a lease contract.
c. Lender: Financer of an assets or a person who finances the leased the assets.
TYPES OF LEASE CONTRACT
There are basically two types of lease contract uses in business house that can be
explained in the following manner:

(1) Operating Lease

It is a cancelable contractual arrangement under which the lessee agree to make
periodic payment to the lessor generally for five or less than five years to obtain the
exclusive right to use the assets.
It is a cancelable contractual arrangement at the option of the lessee.
Lessee may be penalized for the cancellations.
Total payment made by the lessee is less than the initial cost of the leased assets.
Maintenance cost and insurance premium showing be afforded by the lessor itself.
Lease term is generally equals or less than 5 years.

(2) Financial Lease or Capital Lease

It is a non-cancellable longer term contractual agreement under which the lessee agree
to make periodic payment to the lessor to obtain the exclusive right to use the assets
up to the pre-defined period of time.
It is non-cancellable contractual agreement
Total payment over the lease period is higher than the initial cost of the leased assets.
The lessee has an option to purchase the leased assets at bargains price or at fair
market value.
Lease term is equal to 75 percent or more of the estimated life of the property.
Maintenance cost and insurance premium should be afforded by lessee itself.

(3) Leverage Lease

A leverage lease is a third sided arrangement among the lessee, lessor and lender.
Lessee use the assets and makes periodic lease payment.
Lessor purchases the assets and rehire to lessee and collects lease rent.
Lessor invests up to 40 percent to 50 percent of the purchase price.
Lenders supply remaining financing and receive interest payment from the lessor.

Manuf.
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Firm ‘A’ buy

Firm
Firm‘A’ Lessor assets from
‘A’Lessor Firm
Firm‘B’
‘B’Lessee
Lessee
manufacturer
Creditor and equity
shareholder supply
funds

Equity
Equity Creditor
Creditor
Shareholder
Shareholder (lender)
(lender)
 The lender has a first lien on the assets.
The lease rent are directly made to the lender in the event of loan default.

(4) Sale and lease back arrangement

A contractual arrangement occurs when a company sell own asset to another firm and
immediately lease it back.
The lessee receives cash flow from the sale of an asset.
The lessee makes periodic lease payment and retaining use of the assets.

(5) Direct lease

A lease contract under which lessors owns or acquires the assets and then are leased
to a lessee. In other words, direct lease is a lease under which a lessor owns/acquires
the assets that are leased to a given lessee.

Advantages of Lease Contract for the view point of lessee.

a. Advantage of Lease Contract.
(i) Lease rent help to shield tax or lease rent is tax deductible.
(ii) It helps to avoid huge initial investment.
(iii) Risk of obsolete is always transferred to the lessor.
(iv) Borrowing power is retained by lessee because of high liquidity ratio.
(v) It helps to acquire assets within a short period of time.
(vi) Lower maintenance cost is afforded by the lessee in some special contractual
arrangement.
b. Disadvantage of Lease Contract
(i) High cost
(ii) Loss of ownership benefit
– Loss of tax saving on depreciation
– Loss of salvage value
– Loss of investment tax credit.
(iii) Lease payment must be paid in the case of bankruptcy.
(iv) In the case of capital contract, lessee must maintain the leased property.
PRACTICAL PROBLEMS

PROBLEM–1 (a) The Ritu Company produces industrial machines, which have five- year lives.
Ritu is willing to sell the machines for 30,000 or lease them at a rental rate, because of competitive
factors, yields an after-tax return to Ritu of 6 percent–its cost of capital. What is the company's
competitive lease-rental rate? (Assume straight-line depreciation, zero salvage value, and an
effective corporate tax rate of 40 percent.)
(b) The Minu Machine Shop is contemplating the purchase of a machine exactly like those rented
by Ritu. The machine will produce net benefits of Rs.10,000 per year. Minu can buy the machine for
Rs.30,000 or rent it from Ritu at the competitive lease-rental rate. Minu’s cost of capital is 12
percent, its cost of debt 10 percent, and tax rate 40 percent. Which alternative is better for Stockton?
Ans: (a) L1 = Rs. 7,869.718 (b) PV of leasing = Rs. 19,890 PV of purchasing = 19,890 lease

PROBLEM–2 The Bagmati Company is faced with the decision of whether it should purchase or
lease a new forklift truck. The truck can be leased on an eight year contract for Rs. 4,641.44 a year
or it can be purchased for Rs. 26,000. The salvage value of the truck after eight years is Rs. 2,000.
The company uses straight-line depreciation. The discount rate applied is its after-tax cost of debt.
The company can borrow at 15 percent and has a 40 percent marginal tax rate and a 12 percent cost
of capital.
a. Analyze the lease versus purchase decisions using the firm's after-tax cost of debt as the
discount factor.
b. Discuss your results.
Ans: (a) PV of leasing = Rs. 15,413.67;
PV of purchasing = Rs. 18,354.58 (b) Lease the truck.
PROBLEM–3 The Nabin Company seeks to acquire the use of a rolling machine at the lowest
possible cost. The choice is either to lease one at Rs. 21,890 annually or to purchase one for Rs.
54,000. The company's cost of capital is 14 percent, its cost of debt is 10 percent, and its tax rate is 40
percent. The machine has an economic life of six years and no salvage value. The company uses
straight-line depreciation. The discount rate applied is the after tax cost of debt. Which is the less
costly method of financing?
Ans: PV of leasing = Rs. 64,583.82; PV of purchase = Rs. 36,297.68; Purchase the machine
PROBLEM–4 Given the following information, compute the annual lease payment that a lessor will
require. (Lease payments are in advance.)
a. Purchase price of Rs. 260,000, interest rate of 13 percent, 5-year lease period, and no residual
value.
b. Purchase price of Rs. 138,000, interest rate of 6 percent, 9-year lease period, and a near certain
residual value of Rs. 20,000.
c. Purchase price of Rs. 773,000, interest rate of 9 percent, 10-year lease period, and no residual
value.
Ans: (a) Rs. 65,417.03 (b) Rs. 17,498.68 (c) Rs. 110,504.35

7
PROBLEM–5 Digambar wishes to acquire a Rs. 1,00,000 multifaceted cutting machine. The machine
has a useful life of 8 years, after which there is no expected salvage value. If it were to lease finance
the machine over 8 years, annual lease payments of Rs. 16,000 would be required, payable in
advance. The company also could borrow at a 12 percent rate. The asset falls in the 5-year property
class for cost recovery (depreciation) purposes and the company has a 35 percent tax rate. What is
the present value of cash outflows for each of these alternatives, using the after-tax cost of debt as
the discount rate? Which alternative is preferred?
Ans: Cost of leasing = Rs. 67,448.4, Cost of purchasing = Rs. 71,455.62
 PROBLEM–6 In Problem 6, suppose now the machine were expected to have a scrap value of Rs.
14,000 at the end of year 8. Using the internal-rate-of-return method of analysis, determine the best
alternative. Does it differ from your answer to Problem 6?
Ans: Kdt = 7.8%, IRR = 8.17%
PROBLEM–7 Shyam Inc., wants to acquire a mechanized feed spreader that costs Rs. 80,000. The
Shyam company intends to operate the equipment for 5 years, at which time ti will need to be
replaced. However, it is expected to have a salvage value of Rs. 10,000 at the end of the fifth year.
The asset will be depreciated on a straight-line basis (Rs. 16,000 per year) over the 5 years, and
Shyam is in a 30 percent tax bracket. Two means for financing the feed spreader are available. A
lease arrangement calls for lease payments of Rs. 19,000 annually, payable in advance. A debt
alternative carries an interest cost of 10 percent. Debt payments will be at the start of the 5 years
using mortgage type of debt amortization.
a. Using the present-value method, determine the best alternative.
b. Using the internal-rate-of-return method, which is the best alternative? Does your answer
differ from that to part a?
Ans: (a) Cost of leasing = Rs. 59,985.66,
Cost of purchasing = Rs. 55,327.28 (b) Kdt = 7%, IRR = 10.12%
Ans: NPV = – Rs. 55616
Ans: 11.28%
PROBLEM–8 Fez Fabulous Limited wishes to acquire a Rs 10,00,000 multifaceted cutting machine.
The machine has a useful life of 8 years. The expected salvage value at the end of life is Rs 1,40,000.
If it were to lease finance the machine over 8 years, annual lease payments of Rs 1,60,000 would be
required, payable in advance. The company also could borrow at a 10 percent rate. The asset falls
in the 5-years property class for cost recovery (depreciation) purposes, where the rates through
year 1 to 6 are 20%, 32%, 19.2%, 11.52% and 5.76% respectively. And the company has a 40 percent
tax rate. Using the internal-rate-of-return method of analysis, should the company go for leasing or
owning? Determine the best alternative.
Ans: (i) 7.84%

PROBLEM–9 From the information given below, how do you make lease versus purchase decisioin
using internal rate of return analysis:

Cost of the asset Rs 220,000

Lease payment 28,000
Life of the asset 10 years
Before tax cost of debt 10%
Applicable tax rate 40%
Investment tax credit Rs 20,000
Method of depreciation followed is straight line depreciation
Ans: IRR = 4.77%

PROBLEM–10 A certain machine could be either purchased for Rs 15,000 or lease for 3 years. The
lease payments would be Rs 6,600 per year to be paid at the end of years, 1, 2, and 3. If the machine
were purchased, annual depreciation charges would be Rs 3,000, and the machine would be
financed with a 3-year term loan at 9 percent requiring equal end of year payments of Rs 5,926
each. The annual lease payments include a maintenance contract on the machine over the lease’s
term. The firm estimates that, without the maintenance contract, the annual mainenance expense
 related to the machine would be Rs 600 per yeasr. The after-tax salvage value of the machine at the
end of the third year is estimated to be Rs 6,000 if the purchases alternative is chosen. The firm is in
a 50 percent tax bracket and its before tax cost of debt is 9 percent. Should the firm purchase or
lease the machine?

Ans: PV of leasing = Rs 9,071.7; PV of purchas = Rs 6,443.4; Purchase the machine

Problem 2:

(a)
Alternative 2: Leasing
Present value of cost of leasing
1 2 3 4 5 6
End of Lease Tax shield (2) Cash outflows after PVIFA at Present value of
year payment × 0.40 taxes (1) – (2) 9% cash outflows
1-8 Rs. 4,641.44 1,856.576 Rs. 2,784.864 5.5348 Rs. 15,413.67
Alternative 2: Purchasing
Present value of cost of purchasing
First calculation of installment
Installment = = = =Rs. 5,794.13
Second preparation of amortization schedule
Year Installment Interest Principal Loan balance
1 Rs. 5,794.13 Rs. 3,900 Rs. 1,894.13 Rs. 24,105.87
2 Rs. 5,794.13 3,615.88 2,178.25 21,927.62
3 Rs. 5,794.13 3,289.14 2,504.99 19,422.63
4 Rs. 5,794.13 2,913.39 2,880.74 16,541.89
5 Rs. 5,794.13 2,481.28 3,312.85 13,229.04
6 Rs. 5,794.13 1,984.36 3,809.77 9,419.27
7 Rs. 5,794.13 1,412.89 4,381.24 5,038.03
8 Rs. 5,794.13 756.10 5,038.03
Third calculation of the after tax cash outflow of purchasing

Year Installment Depreciation Interest Tax CFAT PVIF PV

in Rs. shield in at 9%
Rs.
1 Rs. 5794.13 3,000 Rs.3,900 2,760 3,034.13 0.9174 2,783.51
2 Rs. 5794.13 3,000 3,615.88 2,646.35 3,147.78 0.8417 2,649.49
3 Rs. 5794.13 3,000 3,289.14 2,515.66 3,278.47 0.7722 2,531.63
4 Rs. 5794.13 3,000 2,913.39 2,365.36 3,428.77 0.7084 2,428.94
5 Rs. 5794.13 3,000 2,481.28 2,192.51 3,061.62 0.6499 2,340.69
6 Rs. 5794.13 3,000 1,984.36 1,993.74 3,800.39 0.5963 2,266.17
7 Rs. 5794.13 3,000 1,412.89 1,765.16 4,028.97 0.5470 2,203.85
8 Rs. 5794.13 3,000 756.10 1,502.24 4,291.89 0.5019 2,154.10
Total PV of cash outflow 19,358.38
Less: PV of after tax salvage value (Rs. 2,000 × 0.5019) 1,003.80
Net present value of cash outflow under purchasing 18,354.58
Working notes:
Calculation of depreciation
Depreciation =
= = Rs. 3,000 per year
(b)
 The Norton Company should choose leasing alternative because present value of cash outflow under this alternative is less
than that of purchasing alternative.
Alternatively,
Analysis of lease versus purchase decision using NAL method
NAL = Cost of asset – PV of ownership benefit – PV of after tax lease rent
= I0 – [ITC + dep×t PVIFA (kdt%, n years) + After tax salvage value × PVIF (kdt%, n years) – Lt (1 – t) (PVIFA (kdt
%, n years)
= Rs. 26,000 – Rs. 0 – Rs. 3,000 (0.40) × PVIFA (9%, 8 years) – Rs. 2,000 × PVIF (9%, 8 years) – Rs. 4,641.44 (1 –
0.40) × PVIFA (9%, 8 years)
= Rs. 26,000 – Rs. 0 – Rs. 1,200 × 5.5348 – Rs. 2,000 × 0.5019 – Rs. 2,784.864 × 5.5348
= Rs. 26,000 – Rs. 6,641.76 – Rs. 1,003.80 – Rs. 15,413.665
= Rs. 2,940.775
The norton company should choose leasing alternative because the net advantage to leasing is positive. In other word, Norton
Company can save Rs. 2,940.775 by using leasing alternative.