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Leveraged leasing.

Leveraged Leasing

Very often in the course of work, an accountant will come across leveraged leasing in the financing and/or accounting areas. In order to meaningfully and critically look into such transactions, the accountant will need a general overall understanding of leveraged leasing.

A leveraged lease is a long-term lease in which a major part of the purchase price of the to-be-leased asset is financed by a third party. Thus, the lessor uses a combination of its own funds and borrowed money to purchase the asset (requiring large capital outlays) that is then leased to another party.

The Structure

The technique is related to an orthodox equipment lease. However, in a leveraged lease the major fragment of the cost of the equipment is refinanced (by mortgaging the lease to a term lender). It follows, therefore, that unlike an ordinary lease where there are only two parties involved (the lessee and the lessor), in a leveraged lease there are three parties (the lessee, the lessor and the term lender).

The Parties Involved

It is possible for parties to play more than one role when additional financing techniques and/or security are integrated. (Examples: a stand-by letter of credit by a major bank may be inserted as security; the lessor can participate as a term lender, also.)

Term Lender: Ordinarily, this is a bank, a superannuation fund or an insurance company. For providing on a "non-recourse" basis 60-85% of the purchase price to the lessor, the term lender receives debt service from the lessor. The implication of the "non-recourse" basis is that the term lender has no legal recourse against the lessor in the event of a failure to meet debt repayments (in other words, the term lender can look only to the security). The security is a chattel mortgage over the lease and an assignment of the lease rentals (generally, no charge is taken over the equipment subject to the lease). The term loan may be in foreign currency named loan funds or on fixed/floating rates. In cases where the asset being financed is very costly, it is usual to have a number of lessors and a consortium of lenders. One of the lessors, in such a case, acts as the packager arranging the leveraged lease.

The Lessor: The lessor contributes 15% - 40% of the purchase price of the asset and claims the tax benefits of ownership of the leased equipment along with any surplus rents (after debts repayments have been met). As a result of the tax benefits (accelerated depreciation deductions; interest expense for interest paid to the term lender; management fees paid to the packager and others; investment tax credit) the lessor is usually able to offer: (a) the lessee, lower interest rates (2-3%) vis-a-vis orthodox leasing, and (b) the term lender, a bigger rate of return vis-a-vis conventional loans. Moreover, these tax benefits (emanating from only a part of the full cost of the leased equipment) generate timely cash flows (tax savings from expenses and deductions; net lease rentals i.e., gross lease rentals repayments; deferral of tax liabilities (e.g., treating interest on accrual basis while treating rent on a cash receipt basis), which on account of the time value of money has quantifiable value) for the lessor. As a matter of fact, it is possible for the lessor's initial outlay to be eclipsed by the recovery of funds. The lessor must, however, follow carefully the IRS guidelines regarding a "true lease" (as against a conditional sales contract). The lessor will receive any salvage value resulting from the disposal of the asset at the termination of the lease. Estimation of salvage value remains difficult. If the lessor assumes a zero salvage value, then the resulting higher lease terms will make the lessor less competitive. Another approach is to use the simultaneous sale of a call option and purchase of a put option on the residual value of the leased equipment (option straddle). All these aspects make leveraged leasing very attractive.

The Lessee: The lessee must have good credit ratings, and receives all revenues from the leased equipment in return for periodical rental payments.

The Evaluation

There is debate on a single discount/reinvestment rate acceptable for computing the relative attractiveness of a leveraged lease to a prospective lessor. Basically, there are three popular methods, viz., the internal rate of return (IRR), the net present value (NPV) and the sinking fund (the other methods being: the return on invested capital; effective rate of return; net terminal value). All these methods will lead to the same decision regarding an acceptance/rejection. 1. IRR can be used for orthodox

capital investments, but becomes

problematic for unorthodox

investments.

(Examples: (a) Two IRRs

would result when there are

positive net cash flows to the

lessor during the early years,

followed by negative cash

flows later in the lease. In

other words, there can be as

many IRRs as there are changes

in the equipment's future cash

flows. (b) Cash flows under

the lease are re-invested at

the IRR when these rates are

very high. 2. The PV method is accepted

as providing a correct solution

to the problem.

PV = A - PV(DTS) - ITC - PV(ITS) - PV(S)

Where: PV = present value

of after tax lease payments

(discounted at a rate with their

riskiness)

A = purchase price of the

leased equipment

PV(DTS) = present value of

tax savings to the lessor as a

result of depreciation (cost of

borrowed funds can be used

to discount the tax savings)

ITC = investment tax credit

to the lessor when the equipment

is acquired

PV(ITS) = present value of

interest tax savings to the lessor

due to tax deduction of interest

expense (cost of debt can

be used to discount the tax

savings)

PV(S) = present value of the

estimated after tax salvage

value of the equipment. 3. Under the sinking fund

method, the positive cash flows

of the early years also fund

the investment required to

offset the negative flows of

later years. The size of the

fund and the contribution

required will determine the

rate at which the sinking fund

is to be re-invested. The return

on the investment will be the

discount rate that equates the

cash inflows not required (for

the sinking fund). 4. The return on invested capital

method is the interest rate

which gives a future value of

zero to the project when the

project's balance each year is

compounded (at the return

on invested capital if the

balance is negative or, at the

cost of capital if the balance

is positive).

In closing, the demand for

leveraged leasing will remain a

function of term financing and

huge dollar equipment needs.

Ashok Roy joined the TVA Federal Credit Union in 1987 as the assistant to the president/policy & procedures analyst. Formerly, he worked in the Bank of Baroda, an international bank, in middle management. His research interests include all aspects of the financial services industry, international business, and finance. Dr. Roy has published over 25 articles covering a wide variety of subjects. He has a bachelor of law degree from the University of Calcutta and a PhD in business from Sardar Patel University in India. He also has a graduate associate degree in banking from the Chartered Institute of Bankers in London, England.
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Author:Roy, Ashook
Publication:The National Public Accountant
Article Type:column
Date:Aug 1, 1990
Words:1214
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